FOREIGN  EXCHANGE 

THE  FINANCING  MECHANISM 
OF  INTERNATIONAL  COMMERCE 


BY 
EDGAR  S.  FURNISS,  Ph.D. 

PROFESSOR   OF   SOCIAL   AND    POLITICAL   SCIENCE 
IN    YALE   UNIVERSITY 


HOUGHTON  MIFFLIN  COMPANY 

BOSTON   NEW  YORK    CHICAGO   SAN  FRANCISCO 


i  0  8 1  (-5  5 


COPYRIGHT,  1922 

BY  EDGAE  S.  FURNISS 
ALL  SIGHTS  RESEKVED 


CAMBRIDGE  •  MASSACHUSETTS 
PRINTED  IN  THE  U.S.A. 


I  PREFACE 

practice  of  most  writers  on  Foreign  Exchange  is  to  treat 
^  ..  subject  as  a  phase  of  the  banking  problem,  emphasizing 

tii^  bankers'  methods  of  handKng  foreign  bills  of  exchange, 
and  giving  but  minor  stress  to  the  relations  of  the  business 
man  with  the  exchange  markets.     It  is  the  opinion  of  the 
present  writer  that  the  needs  of  the  business  world  and  of  the 
student  are  not  adequately  met  by  this  common  method  of 
presenting  the  subject.     The  rapid  expansion  of  the  foreign 
"^     trade  of  the  United  States,  coupled  with  the  abnormal  condi- 
v>^    tion  of  the  exchange  markets  of  the  world,  has  increased,  on 
'^     the  one  hand,  the  importance  of  foreign  bills  in  the  transac- 
^V  tions  of  our  business  men,  and,  on  the  other,  the  problems  of 
national  welfare  and  national  policy  which  are  the  especial 
concern  of  the  student.     This  volume  is  written  with  a  view 
toward  bringing  into  greater  prominence  these  somewhat  neg- 
^    lected  aspects  of  the  subject  of  Foreign  Exchange.    Without 
"^ '  neglecting  the  banking  mechanism  through  which  the  bills  of 
exchange  pass,  the  attempt  is  made  to  bring  the  discussion  to 
bear  upon  the  problems  of  the  business  man  concerned  with 
foreign  trade,  as  well  as  upon  the  broader  questions  of  na- 
tional policy. 

In  stating  and  developing  the  basic  principles  of  the  subject, 
^  it  has  been  necessary  to  assume  a  normal  state  of  the  exchange 
i  market,  such  as  existed  prior  to  the  Great  War.  This  method 
X^  of  treatment  does  not,  however,  place  the  book  out  of  relation 
to  present-day  problems  of  the  exchange  markets.    Wlicrever 
significant  changes  have  taken  place  in  the  practice  of  the 
markets,  allusion  is  made  to  these  changes  at  appropriate 
points  in  the  text  as  a  means  of  emphasizing  and  qualifying 
the  normal  practices.     That  there  is  need  for  a  thorough  un- 
derstanding of  the  principles  which  normally  govern  is  daily 
disclosed  by  the  devices  which  are  put  forward  as  remedies  for 
existing  abnormalities,  and  the  attempts  which  arc  made  to 


iv  PREFACE 

explain  the  present  situation  by  tlie  logic  of  post  hoc  ergo 
propter  hoc.  After  nil,  our  present  difficulties  are  produced  by 
the  outworkini^  of  the  same  forces  which,  in  normal  times, 
govern  the  markets  unnoticed.  We  cannot  understand  the 
situation  to-day,  much  less  effect  an  intelligent  correction  of 
it,  witliout  a  thorough  comprehension  of  normal  principles. 

No  claim  is  made  tliat  this  book  contains  an  original  con- 
tribution to  the  subject;  it  attempts  only  to  make  our  knowl- 
edge of  Foreign  Exchange  more  accessible  and  intelligible  to 
the  business  man  and  the  student.  The  writer  has  found  it 
impracticable  to  refer  at  each  point  to  the  published  work  of 
others  upon  which  he  has  drawn,  for  his  indebtedness  is 
difficult  to  measure.  Especial  mention  should  be  made  of 
Goschen's  The  Theory  of  the  Foreign  Exchanges,  Spaulding's 
Foreign  Exchange  and  Foreign  Bills,  Whitaker's  Foreign  Ex- 
change, and  of  the  publications  of  the  New  York  banks  and 
the  Federal  Reserve  Board.  To  Mr.  Karl  Llewellyn,  formerly 
of  the  faculty  of  the  Yale  Law  School  and  now  of  the  legal 
department  of  the  National  City  Bank,  I  am  particularly  in- 
debted for  contributions  to  the  legal  phases  of  the  subject 
and  for  helpful  criticism  of  a  large  part  of  the  manuscript. 

Edgab  S.  FusNisa 
Yale  Univehsitt 
New  Haven,  Conn. 


CONTENTS 

Introduction.    By  Allyn  A.  Young      .      .      .      .      .      .     ix 

Chapter  I.  Nature  and  Use  of  Bills  of  Exchange       .      .      1 

I.  Introductory  —  2.  Definitions  —  3.  Commercial  use  of  bills  of 
exchange  —  4.  Banking  relations  created  by  foreign  bills  of  ex- 
change—  5.  Clearing  the  accounts  of  the  bankers  in  foreign  ex- 
change. 

Chapter  II.  Demand  and  Supply  of  Bills  of  Exchange      .    21 
6.  Sources  of  demand  and  supply  of  bills  of  exchange  —  7.  Inter- 
national purchase  of  services  —  8.  International  trade  in  securities 

—  9.  International  payments  of  interest  and  dividends  — 10. 
Travelers'  expenditures,  immigrants'  remittances,  and  the  like  — 

II.  Short-term  loans  between  financial  centers  —  12.  Summary  of 
demand  and  supply  factors  of  the  exchange  market  —  13.  Balanc- 
ing international  payments  by  means  of  bills  of  exchange. 

Chapter  III.  Rates  of  Exchange 40 

14.  Determining  factors  of  the  rates  of  exchange  — 15.  Money 
factors  and  the  mint  pars  of  exchange  —  16.  Market  fluctuations 
of  the  exchange  rates  —  17.  The  specie  points  —  18.  Determina- 
tion of  the  specie  points  —  19.  The  gold  exchange  standard  — ■ 

20.  Causes  of  abnormal  fluctuations  in  the  rates  of  exchange  — 

21.  Relation  of  the  exchange  bankers  to  the  rates  of  exchange. 

Chapter  IV.  Interrelations  of  the  Rates  of  Exchange    .    83 

22.  The  schedule  of  rates  in  the  same  market  —  23.  The  cable  rate 

—  24.  The  rate  for  bankers'  long  bills  —  25.  Rate  of  exchange  for 
commercial  bills  —  26.  Arbitrage  —  27.  Speculation. 

Chapter  V.  The  Rates  of  Exchange  and  the  Currents  op 
Commerce 109 

28.  Fluctuations  of  the  rates  caused  by  the  balance  of  payment  — 

29.  Reaction  of  the  rates  of  exchange  upon  the  currents  of  trade  — 
80.  Fluctuations  of  the  rates  caused  by  a  depreciated  currency  — 
31.  The  silver  exchanges  and  their  relation  to  international  com- 
merce —  32.  National  interest  as  affected  by  fluctuations  of  the 
rates  of  exchange  —  33.  The  embargo  on  gold  —  34.  Pegging  the 
rate  of  exchange. 

Chapter  VI.  Bankers'  Bills  of  Exchange       ....  130 
35.  Bankers'  demand  drafts  and  cal)lcs  —  36.  Bankers'  long  bills 

—  .37.  Finance  bills  —  38.  The  dollar  loaD  — 39.  The  sterling 
loan. 


vi  CONTENTS 

Chapter  VII.  Commercial  Bills 159 

40.  Dofinition  and  classification  —  41.  Commercial  long  bills  — 
ii.  Documentary  commercial  bills  —  43.  Documentary  instruc- 
tions   14.  Documentary    acceptance    bills  —  45.  Documentary 

payment  bills  —  4(>.  Clean  bills  —  47.  Commercial  bills  at  sight 
anil  short  sight  —  48.  Modification  of  the  commercial  bill. 

Chapter  VIII.  Letters  of  Credit          205 

49.  Purpose  and  nature  of  letters  of  credit  —  50.  Commercial  let- 
ter of  credit  issued  by  a  bank  upon  itself  —  51.  Letter  of  credit  is- 
sued upon  a  second  bank  —  5i.  Banking  relations  involved  in  let- 
ter of  credit  —  53.  Superiorities  of  the  commercial  letter  of  credit 

—  54.  Travelers'  letters  of  credit  —  55.  Travelers'  checks. 

Chapter  IX.  Other  Forms  of  Bank  Credit      ....  240 

86.  Variations  of  the  bank  credit  —  57.  Acceptance  credits  estab- 
lished by  the  exporter  —  58.  The  authority  to  purchase  —  59.  Re- 
lation of  bank  credits  to  the  exchange  market. 

Chapter  X.  Services  of  Bills  of  Exchange  in  Foreign 
Trade 259 

60.  Summary  of  the  methods  of  making  payment  by  means  of  bills 
of  exchange  —  61.  Distribution  of  risk  by  means  of  bill  of  exchange 

—  62.  The  allocation  of  the  transportation  and  financing  costs  — 
63.  How  the  risk  of  exchange  is  handled  —  64.  Economic  func- 
tions of  commercial  bills  —  65.  The  collection  function  of  bills  of 
exchange  —  66.  The  financing  function  of  bills  of  exchange. 

Chapter  XI.  Foreign   Investments   and   the   Exchange 
Market 295 

67.  Investments  in  long  bills  of  exchange  —  68.  Foreign  long-term 
investments  —  69.  The  effect  of  investments  on  international 
commerce  —  70.  Investment  trusts. 

Chapter  XII.  The  Exchange  Market  —  London         .      .  313 

71.  Correspondent  relations  between  London  and  foreign  banks  — 

72.  The  foreign  balance  —  73.  The  acceptance  account  —  74. 
Commission  charges  of  London  correspondent  banks  —  75.  The 
London  discount  market  —  76.  Relation  of  the  London  banks  to 
the  discount  market  —  77.  The  bill  brokers  and  discount  houses  — 
78.  The  Bank  of  England  —  79.  The  position  of  the  Bank  of  Eng- 
land Rate  in  the  London  market. 

Chapter  XIII.  The  London  Market  {continued)      .      .      .  343 

80.  The  Bank  Rate  and  the  flow  of  gold  —  81.  Other  expedients 
for  controlling  the  movement  of  gold  —  82.  The  bases  of  London's 
supreniacy. 


CONTENTS  vii 

Chapter  XIV.  The  New  York  Market 366 

83.  Former  position  of  the  New  York  market  —  84.  The  Federal 
Reserve  Act  and  its  relation  to  the  exchange  market  —  85.  The 
present  mechanism  of  the  open  market  in  New  York  —  86.  Pri- 
mary investors  in  the  open  market  of  New  York  —  87.  The  New 
York  bill  brokers  —  88.  The  Federal  Reserve  Bank  in  relation  to 
the  discount  market  —  89.  Dollar  exchange. 

Index '    .      .  405 


FORMS  AND  SPECIMEN  LETTERS 

Page 

Domestic  Bill  of  Exchange 10 

Foreign  Bill  of  Exchange 13 

Depreciation  of  Foreign  Exchange  compared  with  Depre- 
ciation OF  Foreign  Currency 59 

Typical  Exchange  Market  Report 96 

Order  for  Cable  Transfer 134 

Application  for  Foreign  Exchange 135 

Banker's  Sterling  Demand  Draft 136 

Banker's  Sterling  Long  Bill 146 

General  Letter  of  Hypothecation       ....        168,  169 
Documentary  Blank  to  accompany  a  Collection  Bill  of 

Exchange 174 

Trust  Receipts 183,  184,  185 

Application  for  Letter  of  Credit  (Boston  Bank)      .      .  207 
Contract  for  the  Purchase  of  Dollar  Import  Letter  of 

Credit 210 

Import  Letter  of  Credit  (Dollars) 212 

Sterling  Import  Letter  of  Credit  Agreement       .        218,  219 
Import  Letter  of  Credit  (Pounds  Sterling)    ....  223 

Letter  of  Confirmation 224 

Traveler's  Sterling  Letter  of  Credit 235 

Traveler's  Check  in  Dollars 238 

Letter  Confirming  an  Irrevocable  Credit      .      .      ...  243 

Acceptance  Agreement 246,  247 

Letter  of  Guarantee 249,  250 

Authority  to  Draw       .      .    • 253,  254 


INTRODUCTION 

There  appears  to  be  a  fairly  common  impression  that  there  is 
something  peculiarly  mysterious  or  recondite  about  the  sub- 
ject of  foreign  exchange.  Professor  Furniss's  lucid  and  well- 
proportioned  account  should  do  much  to  correct  that  im- 
pression. The  truth  is  that  the  operation  of  the  foreign  ex- 
changes is  in  many  respects  simpler  and  less  obscure  than  that 
of  other  parts  of  our  monetary  mechanism.  That  the  subject 
has  this  undeserved  reputation  for  obscurity  must  be  at- 
tributed, I  suppose,  to  the  manner  in  which  the  books  have 
dealt  with  it. 

Books  on  foreign  exchange  fall  for  the  most  part  into  two 
classes.  First,  there  are  the  books  that  are  weighted  down 
with  purely  technical  details  respecting  such  matters  as 
monetary  standards,  commercial  laws,  stamp  taxes,  the  arith- 
metic of  exchange  rates,  and  the  like  —  excellent  desk  books, 
doubtless  (if  only  they  could  be  kept  up  to  date) ,  for  dealers 
in  exchange.  Second,  there  are  the  more  philosophical  dis- 
cussions, dealing  with  the  general  principles  of  foreign  ex- 
change. Too  many  of  the  books  of  this  second  type  make  the 
subject  unduly  obscure  by  making  it  unduly  abstract  and 
unreal  or  by  entangling  it  with  the  intricate  problems  of  the 
general  theory  of  international  trade. 

Professor  Furniss  has  chosen  a  middle  course.  On  the  one 
hand  he  is  careful  to  avoid  petty  technical  detail.  On  the 
other  hand  he  is  equally  careful  to  keep  close  to  concrete 
realities.  For  these  reasons,  I  believe,  his  book  will  commend 
itself  to  two  different  classes  of  students.  Those  who,  in 
schools  of  commerce  or  elsewhere,  are  preparing  themselves 
for  business  careers  will  find  in  it  an  orderly  account  of  the 
principal  operations  of  the  foreign  exchange  market.  He 
leaves  to  one  side  such  minor  matters  of  detail  as  can  be  more 
profitably  acquired  through  actual  experience  in  the  work  of 
the  foreign  exchange  department  of  a  bank.  Those  whose  inter- 


X  INTRODUCTION 

ests  are  in  economic  science  rather  than  in  affairs  will  find  that 
the  best  ap})roach  to  the  study  of  foreign  exchange —  as  to 
the  stud^v  of  other  monetary  problems  —  is  through  the  anal- 
ysis of  the  actual  mechanism  of  the  market.  In  these  matters 
Professor  Furniss,  wTiting  with  first-hand  knowledge  of  his 
subject,  is  a  safe  guide. 

I  suspect  that  the  largest  use  of  the  book  will  be  as  a  text  in 
colleges  and  schools  of  commerce.  But  other  readers  will  be 
attracted  to  it  by  the  present  importance  of  the  subject  with 
which  it  deals.  During  the  last  few  years  disordered  ex- 
changes have  stood  in  the  way  of  the  full  restoration  of  that 
international  economic  cooperation  upon  which,  under  mod- 
ern conditions,  the  economic  welfare  of  the  world  depends. 
In  foreign  exchange,  as  elsewhere,  our  attention  is  rarely 
drawn  to  certain  of  the  most  fundamental  and  elementary 
features  of  our  monetary  mechanism  until,  for  some  reason, 
that  mechanism  fails  to  operate  smoothly.  In  this  respect,  of 
course,  the  present  volume  has  an  advantage  over  such  de- 
scriptive accounts  of  the  foreign  exchange  market  as  were 
written  before  the  war.  While  avoiding  disproportionate 
emphasis  upon  what  we  may  hope  is  only  a  temporary  phase, 
it  affords  an  excellent  introduction  to  the  study  of  the  factors 
which  determine  the  price  of  exchange  upon  (or  in)  a  coun- 
try with  an  inconvertible  paper  currency.  This  feature, 
quite  apart  from  its  other  qualities,  will  commend  it  to  many 
readers.  ~'~ 

At.t.yn  a.  Young 


FOREIGN  EXCHANGE 

• 

CHAPTER  I 

NATURE  AND  USE  OF  BILLS  OF  EXCHANGE 

1.  Introductory.  When  viewed  as  a  whole,  international 
trade  is  barter;  the  people  of  one  nation  obtain  a  supply  of 
the  goods  and  services  of  other  peoples  by  offering  in  ex- 
change the  peculiar  products  of  their  own  land  and  labor. 
The  ability  of  Americans  to  command  for  their  own  use  a 
share  in  the  production  of  foreign  peoples  is  conditioned  upon 
the  desire  of  foreigners  to  obtain  a  portion  of  our  national 
product.  In  other  words,  our  power  to  import  is  limited  by 
our  ability  to  export.  Conversely,  when  we  consider  all 
nations  outside  our  own  boundaries  as  a  unit,  it  is  apparent 
that  the  ability  of  foreign  peoples  to  buy  our  goods  is  con- 
ditioned upon  our  willingness  to  accept  their  goods  in  ex- 
change, since  they  have  no  other  means  with  which  to  make 
payment.  Hence,  our  power  to  export  is  limited  by  our 
willingness  to  import.  Nations,  like  individuals,  may,  it  is 
true,  fall  into  debt  to  each  other  on  account  of  business 
transactions  which  remain  uncompleted;  but  in  the  long  run, 
men,  whether  in  groups  or  as  individuals,  will  refuse  to  sur- 
render their  wealth  to  one  another  except  in  exchange  for 
other  wealth. 

If  international  trade  were  carried  on  by  national  groups 
instead  of  by  individual  business  men,  the  use  of  the  exchange 
market,  and  of  the  many  different  forms  of  credit  instru- 
ments with  which  our  modern  money  economy  complicates 
the  basic  forces  underlying  the  commerce  of  nations,  would 
to  a  great  extent  disappear;  however,  in  spite  of  these 
complexities,  the  principles  of  barter  are  still  the  governing 


S  FOREIGN  EXCHANGE 

principles  of  international  trade.  This  fact  must  be  firmly 
grasped  at  the  outset  of  any  study  of  foreign  exchange;  for, 
as  we  shall  see  in  due  course,  it  is  the  barter  of  goods  for  goods 
in  international  trade  which  controls  the  operations  of  the 
exchange  markets  of  the  world. 

Since  the  world's  trade  is  not  carried  on  by  national  groups, 
but  by  individual  business  men,  each  in  pursuit  of  private 
profit,  the  problem  of  effecting  payment  in  international 
commercial  transactions  is  one  of  great  importance.  The 
American  manufacturer  or  merchant  who  has  found  a  market 
for  his  goods  outside  our  boundaries  cannot  exploit  this  op- 
portunity to  his  own  advantage  unless  some  agency  is  avail- 
able through  which  he  can  obtain  from  his  foreign  customer 
the  amount  due  him.  It  is  no  aid  to  the  conduct  of  his  busi- 
ness to  be  told  that  the  nation  of  which  he  is  a  member  must 
in  due  course  receive  from  foreign  peoples  payment  in  goods 
for  all  commodities  exported.  The  problem  of  the  individual 
trader  is  immediate  and  practical;  he  must  receive  in  dollars 
and  cents,  and  without  too  great  delay,  the  sale  price  of  his 
goods,  otherwise  he  cannot  meet  the  current  expenses  of  his 
business  and  must  withdraw  from  foreign  trade.  At  the 
same  time,  the  peculiar  complexities  of  foreign  trade  deny 
him  recourse  to  many  of  the  means  by  which  he  is  accus- 
tomed to  make  collection  from  debtors  in  the  domestic 
market.  The  distance  which  separates  the  two  parties;  the 
difference  in  language,  business  customs  and  legal  institu- 
tions; the  fact  that  the  foreign  buyer's  money  has  no  cur- 
rency in  the  seller's  market  and  that  his  checks  and  other 
credit  instruments  will  not  be  honored  by  the  seller's  banker, 
increase  the  seller's  reliance  upon  some  agent  capable  of 
bridging  the  distance  between  the  two  markets  and  resolving 
the  sum  of  money  paid  out  by  the  foreign  buyer  in  a  distant 
city  and  a  foreign  coinage  into  a  sum  available  in  the  seller's 
city  and  in  the  coinage  of  his  nation. 

This  need  of  the  exporter  can  be  most  simply  met  by  the 
offer  of  a  third  party  to  assume  the  exporter's  right  against  his 
foreign  customer  and  to  pay  the  exporter,  either  immediately 
or  at  some  definite  future  date,  the  sum  of  money  owing  him. 


NATURE  AND  USE  OF  BILLS  OF  EXCHANGE        3 

If  this  third  party  is  a  neighbor  of  the  exporter  operating 
under  the  same  laws  and  customs,  the  problem  of  financing 
foreign  sales  loses  much  of  its  complexity.  In  actual  prac- 
tice, payment  for  the  greater  part  of  the  world's  international 
trade  is  effected  in  precisely  this  manner:  by  a  transference 
to  a  third  party  of  the  seller's  claim  against  the  buyer  in  con- 
sideration of  a  payment  of  money  by  the  third  party  to  the 
seller.  The  third  party  in  question  is  the  foreign  exchange 
banker;  the  instrument  which  gives  effect  to  the  transfer  of 
rights  is  a  bill  of  exchange. 

2.  Definitions.  As  defined  by  the  Negotiable  Instruments 
Law  a  bill  of  exchange  is  ''an  unconditional  order  in  writing 
addressed  by  one  person  to  another,  signed  by  the  person  giving  it, 
requiring  the  person  to  whom  it  is  addressed  to  pay  07i  demand 
or  at  a  fixed  or  determinable  future  time  a  sum  certain  in  money 
to  order  or  to  bearer."  There  are  three  parties  to  this  transfer 
of  funds:  A  orders  B  in  writing  to  pay  a  stated  amount  of 
money  to  C  (or  his  order)  either  on  demand  or  at  a  definite 
future  time.  These  parties  are  given  distinctive  names:  A, 
who  writes  the  order,  is  known  as  the  drawer;  B,  to  whom  the 
order  is  addressed,  as  the  drawee;  C,  the  recipient  of  the  money 
or  beneficiary  of  the  order,  the  payee.  In  the  market,  bills  of 
exchange  are  differentiated  to  a  certain  extent  according  to 
the  character  of  the  drawers;  thus  the  term,  banker's  bill,  is 
used  to  describe  a  bill  of  exchange  whose  drawer  is  a  banker, 
and  the  term,  commercial  bill,  one  whose  drawer  is  a  merchant 
or  business  man.  The  practical  effect  of  this  classification 
upon  the  treatment  of  the  different  bills  of  exchange  by  the 
exchange  market  will  presently  appear. 

Again,  bills  of  exchange  are  classified  according  to  the 
method  used  for  determining  the  date  upon  which  payment 
is  due  from  the  drawee.  From  the  definition  which  has  been 
given,  it  will  be  seen  that  the  date  of  payment  may  be  cither 
"on  demand"  or  "at  a  fixed  or  determinable  future  date." 
A  bill  of  exchange  payable  on  demand  is  called  a  demand  or 
sight  bill,  or,  frequently,  a  check,  for  ui)on  examination  it  will 
appear  that  the  credit  instrument  known  as  a  check,  so  com- 
monly used  in  domestic  transactions,  answers  all  the  re- 


4  FOREIGN  EXCHANGE 

qiiircmcnts  of  the  definition  for  a  demand  bill  of  exchange. 
All  bills  payable  at  a  future  date  are  grouped  together  as 
time  or  lomj  bills.  But  the  time  bill  may  be  so  worded  as  to 
specify  either  of  two  different  methods  of  determining  the 
future  date  upon  which  payment  is  due.  If  A's  instructions 
to  B,  borne  by  the  face  of  the  order,  read,  "Pay  to  the  order 
of  C  one  hundred  dollars  thirty  days  after  date,"  the  order 
becomes  payable  thirty  days  after  writing  regardless  of  any 
loss  of  time  involved  in  presenting  it  to  B ;  it  may,  therefore, 
result  in  giving  B  less  than  thirty  days  in  which  to  prepare  for 
payment  after  presentment.  On  the  other  hand,  if  A's  in- 
structions read,  "Pay  to  the  order  of  C  one  hundred  dollars 
thirty  days  after  sight,"  the  bill  does  not  commence  its  life 
until  it  has  been  presented  to  B,  who  is  accordingly  allowed 
thirty  days'  time  in  which  to  prepare  for  payment.  In  for- 
eign trade  the  majority  of  time  bills  of  exchange  are  drawn 
payable  after  sight,  though  the  practice  of  making  them 
payable  after  date  is  not  unknown  and  is  growing  in  favor 
for  reasons  which  will  be  discussed. 

In  no  case  may  a  bill  of  exchange  be  drawn  payable  at  a 
date  which  depends  upon  the  occurrence  of  some  non-pre- 
dictable future  event,  for  such  terms  would  violate  the  pre- 
scription of  the  law  that  the  date  of  payment  must  be  either 
fixed  or  determinable.  It  frequently  happens  that  the  basing 
of  the  date  of  payment  of  a  bill  of  exchange  upon  the  arrival 
of  a  ship  or  the  delivery  of  a  consignment  of  goods  would  be 
a  convenience  to  both  buyer  and  seller;  but  these  expedients 
cannot  be  adopted,  for  the  courts  will  hold  that  an  order  so 
drawn  is  not  a  true  bill  of  exchange  and  the  bankers  will 
refuse  to  negotiate  it  because  of  this  weakness.  However,  when 
the  convenience  of  permitting  the  drawee  to  calculate  the 
date  of  payment  on  the  basis  of  such  an  event  is  especially 
great,  informal  custom  often  sanctions  a  departure  from  the 
strict  terms  of  the  order.  Assuming,  for  example,  that  the 
drawee  is  a  South  American  importer  of  merchandise  from 
the  United  States,  and  the  drawer,  the  exporter  to  whom  is 
due  the  sale  price  of  the  merchandise,  the  custom  of  the 
drawee's  market  may  permit  him  to  postpone  payment  of  a 


NATURE  AND  USE  OF  BILLS  OF  EXCHANGE        5 

sight  draft  or  the  calculation  of  the  date  of  payment  of  a 
time  draft  until  the  goods  have  arrived  and  have  been  ex- 
amined. In  fact,  this  custom  is  so  firmly  rooted  in  certain 
South  American  countries  that  the  refusal  of  the  drawee  to 
pay  a  sight  draft  until  after  the  arrival  of  the  goods  leaves 
the  drawer  no  recourse  but  to  acquiesce,  despite  his  apparent 
legal  right  to  enforce  payment  upon  presentation.  Similar 
customs  obtain  in  other  countries,  in  Holland,  for  example, 
where  the  payment  of  a  sight  draft  is  ordinarily  postponed 
until  three  days'  notice  has  been  given  the  drawee.  Because 
of  such  local  customs,  it  is  impossible  to  say  that  demand  or 
sight  drafts  are  always  paid  on  presentation.  In  the  case  of 
time  drafts,  too,  the  date  of  actual  payment  is  somewhat 
aflFected  by  local  laws  regarding  "days  of  grace"  which  ex- 
tend the  date  of  payment  after  maturity  from  one  to  ten  days 
according  to  the  practices  of  the  particular  country  or  state 
in  which  the  drawee  lives. 

Since  the  bill  of  exchange  is  an  order  to  the  drawee  to  pay 
out  a  sum  of  money,  the  drawing  of  the  bill  may  be  taken  as 
presumptive  evidence  that  the  drawer  has  a  legal  right  to 
demand  this  sum  from  the  drawee.  But  it  must  not  be  as- 
sumed that  possession  of  the  bill  of  exchange  bestows  upon 
the  payee  a  right  of  action  against  the  drawee,  even  when  the 
drawer  is  a  bona  fide  creditor  and  has  acted  well  within  his 
powers  in  addressing  the  order  to  the  drawee.  The  posses- 
sion by  C  of  A's  order  instructing  B  to  pay  a  sum  of  money 
gives  C  no  power  to  enforce  the  order  by  legal  action  in  case 
B  chooses  to  disregard  the  instructions.  If  B's  refusal  to 
honor  the  bill  is  a  violation  of  some  agreement  he  has  made 
with  the  drawer,  any  action  brought  against  him  must  be 
brought  by  the  drawer  and  must  be  based  on  his  violation 
of  the  contract  in  pursuance  of  which  the  bill  was  drawn. 

To  transfer  this  right  of  action  against  the  drawee  from 
the  drawer  to  the  payee  of  the  bill  of  exchange,  the  order 
must  be  presented  to  the  drawee  and  receive  his  acknowledg- 
ment. If  the  bill  is  drawn  payable  upon  demand,  the 
drawee's  acknowledgment  of  the  order  will,  of  course,  con- 
sist simply  of  his  payment  of  the  amount  of  money  stated  on 


6  FOREIGN  EXCHANGE 

its  face.  If  it  is  a  time  draft,  however,  the  acknowledgement 
must  be  given  in  such  form  as  to  bestow  upon  the  holder  of 
the  bill  a  rii:;ht  of  action  against  the  drawee  in  case  payment 
is  refused  at  maturity,  and  this  the  drawee  usually  does  by 
writing  the  word  "accepted,"  together  with  his  signature  and 
the  date,  across  the  face  of  the  order.  After  this  act,  whose 
effect  is  to  transmute  the  order  into  the  drawee's  promise  to 
pay  at  a  definite  future  date,  the  bill  of  exchange  will  be 
spoken  of  as  an  acceptance  by  the  business  world  and  may 
change  hands  before  maturity  upon  terms  which  reflect  the 
estimate  placed  by  investors  in  the  acceptor's  willingness 
and  ability  to  discharge  his  debts;  for  now  its  lawful  posses- 
sion will  give  the  holder  legal  right  of  action  against  the 
drawee  (acceptor)  in  case  of  dishonor  at  maturity.  There 
are,  however,  certain  significant  differences  between  the  ac- 
ceptance and  the  ordinary  promissory  note,  but  discussion  of 
these  differences  may  be  postponed  until  the  procedure  in 
event  of  the  drawee's  dishonor  of  the  order  has  been  ex- 
plained. 

Dishonor  of  a  sight  bill  of  exchange  consists  simply  in  the 
drawee's  refusal  to  pay  the  sum  of  money  stated  in  the  order; 
in  the  case  of  a  time  bill,  two  opportunities  to  dishonor  the 
order  are  given  the  drawee:  he  may  refuse  to  give  the  order 
his  acceptance,  or,  having  made  the  acceptance,  he  may 
refuse  to  redeem  the  bill  in  money  at  maturity.  The  last- 
named  form  of  dishonor  is  obviously  different  in  nature  from 
the  other  two,  for  a  refusal  to  redeem  an  accepted  bill  is  a 
repudiation  of  the  drawee's  own  written  obligation,  while 
refusal  either  to  accept  a  time  bill  or  to  pay  a  sight  bill  is 
merely  a  disregard  of  the  drawer's  order.  In  most  cases,  the 
act  of  dishonor  will  be  made  the  cause  of  legal  measures 
against  the  drawee  either  by  the  drawer  or  by  his  representa- 
tive, and  it  is  the  custom  to  improve  the  drawer's  legal 
position  in  preparation  for  the  action  he  will  presently  bring 
against  the  drawee  by  obtaining  a  formal  legal  record  of  the 
fact  that  dishonor  has  occurred.     This  is  called  protest. 

The  formalities  connected  with  the  protest  vary  in  different 
countries  in  conformity  with  variation  in  the  legal  institutions. 


NATURE  AND  USE  OF  BILLS  OF  EXCHANGE        7 

but  the  purpose  is  in  all  cases  much  the  same,  and  the  method 
reflects  to  a  certain  degree  this  uniformity  of  purpose.  The 
holder  of  the  bill  who  has  been  unable  to  obtain  the  drawee's 
acceptance  or  payment  upon  presentation  appears  before  a 
notary  public,  or  similar  public  officer,  and  makes  formal 
protest  against  the  act  of  dishonor.  The  fact  of  the  drawee's 
refusal  being  established,  the  protestor  receives  a  certificate 
bearing  the  notary's  signature  which  becomes  a  legal  record 
that  presentment  has  been  made  and  dishonor  has  occurred. 
It  may  be  well  to  repeat  that  this  action  is  taken  for  the  bene- 
fit of  the  drawer,  to  whom,  accordingly,  all  expenses  connected 
with  the  protest  will  be  charged.  These  expenses  may  be 
so  large,  or  the  virtue  of  the  protest  in  improving  the 
drawer's  position  in  the  courts  may  be  so  slight,  that  the 
action  is  not  deemed  worth  while;  this  is  a  matter  for  the 
drawer  of  the  bill  to  decide,  either  at  the  time  the  bill  is 
originally  transferred  to  the  payee,  or  when,  later,  he  is  in- 
formed that  dishonor  has  occurred.  In  European  countries 
and  in  the  United  States,  protest  is  almost  invariably  made 
unless  the  amount  of  the  dishonored  bill  is  very  small.  In 
some  other  countries,  and  especially  in  certain  South  Amer- 
ican republics,  the  value  of  the  protest  is  scarcely  worth  its 
cost. 

A  bill  of  exchange  before  acceptance  is,  to  repeat,  merely 
an  order  of  the  drawer;  it  is  not  a  promise  to  pay  a  sum  of 
money.  If  the  drawer  succeeds  in  transferring  it  to  a  third 
party  —  banker,  or  dealer  in  foreign  exchange  —  in  exchange 
for  an  immediate  payment,  it  is  because  this  third  party  has 
confidence  in  the  drawer's  willingness  and  ability  to  make 
restitution  in  case  the  order  is  not  obeyed.  The  bill  of  ex- 
change, in  other  words,  should  be  viewed  as  a  credit  instru- 
ment of  the  drawer,  resting  upon  his  signature,  and  obtaining 
its  marketability  from  his  legal  obligation  to  make  good  money 
invested  in  it.  It  is,  indeed,  a  misuse  of  words  to  speak  of  a 
drawer's  selling  a  bill  of  exchange  to  a  banker;  he  does  not,  in 
fact,  sell,  but  borrows,  using  the  bill  as  security  for  the  loan 
and  assuming  a  liability  similar  to  that  borne  by  any  borrower, 
except  that  his  hability  is  contingent  upon  dishonor  by  the 


8  FOREIGN  EXCHANGE 

drawee.  This  liability  of  the  drawer  terminates  only  with 
tlie  payment  of  the  order  by  the  drawee;  in  the  case  of  a 
time  bill,  it  does  not  end,  as  might  be  supposed,  when  the 
drawee's  acceptance  has  been  obtained.  Up  to  the  point  of 
acceptiince,  the  time  bill  of  exchange  rests  solely  upon  the 
credit  of  the  drawer;  after  acceptance,  although  it  becomes 
the  direct  obligation  of  the  drawee,  the  drawer's  name  re- 
mains upon  the  bill  and  his  liability  is  not  removed,  though  it 
now  becomes  contingent  upon  the  drawee's  failure  to  redeem 
his  acceptance  at  maturity. 

To  make  this  clear,  let  us  contrast  the  credit  standing  of  an 
acceptance  with  that  of  a  promissory  note,  by  assuming  that 
the  acceptor  of  a  bill  of  exchange  has  had  occasion  in  the 
course  of  his  business  to  issue  a  promissory  note  of  a  like 
amount.  From  his  point  of  view  there  is  no  difference  in  the 
liability  created  by  these  two  credit  instruments;  both  are 
his  direct  obligations,  and  the  holder  of  either  can  enforce 
payment  by  legal  action  in  case  of  default.  But  from  the 
point  of  view  of  the  creditor  a  significant  difiPerence  obtains. 
If  default  should  occur,  he,  as  holder  of  a  promissory  note, 
would  have  recourse  to  no  other  party  than  the  issuer  of  the 
note,  unless  there  happened  to  be  endorsers.  But,  as  holder 
of  an  acceptance,  he  may  bring  action,  first  against  the  ac- 
ceptor, then  against  the  endorsers  if  there  are  any,  and  finally 
against  the  drawer.  Thus  the  acceptance  is  founded  upon 
the  credit  of  at  least  two  parties,  and  because  of  this  double 
security  it  commands  a  high  investment  standing  which  ex- 
plains in  large  part  the  wide  use  of  time  bills  in  financing 
commercial  transactions.  It  is  our  present  purpose  to  em- 
phasize the  fact  that  the  drawer's  liability  does  not  end  with 
acceptance,  but  extends,  as  a  contingent  liability,  beyond 
that  point  to  the  ultimate  redemption  of  the  bill  of  exchange. 
Many  business  men,  accustomed  to  the  use  of  bills  of  ex- 
change, do  not  fully  realize  the  extent  of  their  liabilities  as 
drawers. 

3.  Commercial  use  of  bills  of  exchange.  The  bill  of  ex- 
change has  its  origin  in  a  creditor-debtor  relationship  which 
places  one  individual  under  the  necessity  of  paying  out 


NATURE  AND  USE  OF  BILLS  OF  EXCHANGE   9 

money  at  the  order  of  another.  This  relationship  may  be 
produced  in  an  indefinite  number  of  ways,  most  common 
among  which  is  the  sale  of  goods,  services,  or  property  rights 
without  advance  payment  of  the  purchase  price.  Every  such 
sale  "on  time"  affords  the  opportunity,  both  parties  agreeing, 
to  effect  payment  by  means  of  a  bill  of  exchange  which  trans- 
fers the  seller's  claim  upon  the  buyer  to  a  third  person  who  is 
willing  either  to  pay  for  it  immediately,  or  to  undertake  the 
collection  of  the  amount  due  and  its  eventual  transference  to 
the  seller.  Many  bills  of  exchange,  however,  arise  not  out 
of  transactions  between  merchants,  but  from  those  between 
bankers,  who  often  create  a  creditor-debtor  relationship  for 
the  express  purpose  of  enabling  one  banker  to  draw  bills  upon 
another  and  sell  them  for  a  profit.  In  this  preliminary  dis- 
cussion, it  will  be  our  purpose  to  give  attention  to  those  uses 
of  bills  which  originate  in  commercial  transactions  between 
business  men  in  different  markets,  for  upon  this  economic 
foundation  rests  the  entire  business  of  foreign  exchange  in  all 
its  many  and  varied  aspects. 

Since  there  is  no  essential  difference  of  principle  to  dis- 
tinguish the  foreign  bill  of  exchange  from  the  domestic,  an 
example  of  the  commercial  use  of  the  latter  and  more  familiar 
form  will  serve  to  illustrate  the  nature  of  both.  Suppose, 
then,  that  a  wholesaler  in  New  York  sells  $5000  worth  of 
linoleum  to  a  jobber  in  Minneapolis,  the  terms  of  sale  pro- 
viding that  the  seller  shall  draw  at  sixty  days'  sight  against 
the  buyer  as  soon  as  the  shipment  has  been  made.  The  goods 
are  shipped  and  the  wholesaler  has  in  hand  the  railroad's 
bill  of  lading  whose  holder  alone  can  demand  delivery  of  the 
goods  in  Minneapolis.  He  now  goes  to  his  banker  in  New 
York  and  arranges  to  transfer  to  him  his  right  to  receive  pay- 
ment from  the  jobber,  the  bill  of  lading  to  pass  to  the  banker 
as  his  security  m  the  transaction.  The  bill  of  exchange  which 
gives  effect  to  this  transfer  of  credit  will  appear  as  shown 
in  Form  1,  page  10. 

The  banker,  relying  upon  the  credit  of  the  shipper  and  upon 
the  additional  security  of  the  bill  of  lading  which  represents 
the  goods  shipped,  may  agree  to  advance  the  full  present 


Accepted 
Payable  at 


October  4,  1921 


Minneapolis  Bank 


Minneapolis,  Minnesota 


(Signed) 


Minneapolis  Jobber 


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NATURE  AND  USE  OF  BILLS  OF  EXCHANGE      11 

value  of  the  bill  at  once,  in  which  case  he  will  discount  the 
face  of  the  draft  for  sixty  days  at  the  ruling  rate  of  interest, 
subtract  his  commission  and  any  other  charges,  and  place  the 
proceeds  —  say,  $4950  —  to  the  wholesaler's  credit.  On  the 
other  hand,  he  may  agree  to  take  the  bill  for  collection  only, 
making  no  payment  until  it  is  redeemed  at  maturity;  or,  he 
may  combine  these  two  policies  by  advancing  a  part  of  the 
face  value  of  the  bill,  holding  the  remainder  in  reserve  as 
additional  security  until  redemption  is  made  by  the  jobber. 
Though  all  three  methods  of  handling  the  bill  of  exchange  are 
to  be  found  in  actual  practice,  we  may  assume  for  the  sake  of 
simplicity  that  the  drawer  in  the  present  instance  receives 
an  advance  of  the  full  present  value.  In  this  case,  he,  the 
wholesaler,  is  out  of  the  transaction;  he  has  made  his  sale, 
shipped  his  goods,  received  his  money,  and  can  go  about  his 
business  without  concern  as  to  the  future  history  of  the  bill 
of  exchange,  except  that  he  will  bear  a  contingent  liability  to 
refund  the  money  to  the  banker  in  case  the  jobber  refuses  to 
accept  or  to  pay  the  draft.  At  this  point  one  of  the  chief 
functions  of  the  commercial  bill  of  exchange  appears :  it  makes 
possible  the  sale  of  goods  on  credit  and  yet  may  provide  im- 
mediate payment  for  the  seller. 

Let  us  follow  the  transaction  further.  The  draft,  which 
has  been  drawn  payable  to  the  New  York  banker,  is  endorsed 
by  him  and  sent  forward  with  the  bill  of  lading  to  a  bank 
in  Minneapolis.  It  is  presented  to  the  jobber,  who  writes 
"accepted"  and  signs  his  name  across  the  face,  thereby  as- 
suming the  obligation  of  redeeming  it  at  maturity.  If  the 
jobber's  promise  to  pay  is  acceptable  to  the  Minneapolis  bank 
without  further  security,  he  may  then  take  the  bill  of  lading 
and  obtain  his  goods  from  the  railroad  company.  For  him, 
too,  the  transaction  is  temporarily  closed :  he  has  the  goods  in 
his  possession  and  may  proceed  to  make  his  sales  and  deliver- 
ies to  the  retailers.  For  sixty  days  the  draft  must  be  held  by 
the  Minneapolis  banker,  or  by  some  one  else  who  has  bought 
it  as  an  investment;  during  this  time  it  will  be  growing  in 
value  as  interest  accrues,  until  at  maturity  it  becomes  worth 
its  face  —  $5000.  .  lief  ore  his  acceptance  falls  due,  the  jobber 


12  FOREIGN  EXCHANGE 

will  have  deposited  with  his  bank  funds  sufficient  to  meet  his 
ol^ligation  and  out  of  these  funds  he  will  pay  the  $5000  he 
owes.  Here  appears  another  function  of  the  commercial  bill 
of  exchance:  payments  due  between  merchants  far  removed 
from  each  other  are  made  with  ease,  both  creditor  and  debtor 
dealing  only  with  a  neighborinj:;  banker  in  his  own  market. 
There  then  remains  the  relationship  created  between  the  two 
banks  concerned  with  the  bill  of  exchange.  Money  paid  out 
by  a  bank  in  New  York  has  been  returned  with  increase  to  a 
bank  in  ISlinneapolis,  held  there  to  the  credit  of  the  New  York 
bank.  We  shall  not,  at  present,  inquire  into  the  methods  em- 
ployed to  dispose  of  this  credit,  reserving  this  problem  for 
discussion  in  another  place. 

If  in  the  preceding  illustration  the  goods  had  been  sold  in  a 
foreign  market,  the  bill  of  exchange  by  which  payment  was 
effected  would  have  differed  in  no  essential  respect.  The 
foreign  bill  of  exchange,  in  a  transaction  similar  to  the  fore- 
going, would,  however,  be  drawn  in  the  money  of  the  debtor's 
country  and  sold  by  the  creditor  for  its  equivalent  in  the 
money  of  his  own  country.  This  involves  the  translation  of 
one  monetary  system  into  another  and  requires  a  determina- 
tion of  the  relative  values  of  the  standard  coins  of  the  two 
systems.  For  example,  a  cotton  dealer  in  New  York  sells  a 
number  of  bales  of  cotton  to  a  Lancaster  spinner,  who  has 
agreed  to  accept  a  sixty-day  sight  draft  for  the  amount  of  the 
shipment.  The  importer  will,  of  course,  pay  in  the  money 
of  his  own  country  and  the  exporter  in  drawing  upon  his 
foreign  customer  must  transfer  to  the  buyer  of  the  bill  the 
right  to  receive  the  money  which  will  actually  be  paid  —  say 
two  thousand  pounds  sterling.  WTien  the  cotton  is  aboard 
the  steamer,  consigned  to  the  buyer  and  insured  against  loss 
in  transit,  the  seller  takes  his  bill  of  lading  and  insurance  pol- 
icy to  his  banker  in  New  York  and  transfers  to  him  the  right 
to  receive  the  two  thousand  pounds  from  the  Lancaster 
spinner  sixty  days  after  the  bill  has  been  accepted.  The 
draft  by  which  this  transfer  of  credit  is  made  will  appear  as 
in  Form  2,  page  13. 

The  necessity  of  translating  two  thousand  pounds  sterling 


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14  FOREIGN  EXCHANGE 

into  dollars  and  cents  arises  during  the  negotiations  between 
the  exporter  and  his  hanker.  When  this  has  heen  done,  if  the 
face  value  of  the  bill  is  to  be  advanced  to  the  drawer,  the  dis- 
count and  commission  charges  will  be  subtracted,  and  the 
proceeds  paid  out  by  the  banker.  For  the  exporter,  aside 
from  his  risk  of  being  required  to  make  restitution  in  case  of 
default  by  his  foreign  customer,  the  transaction  is  now  com- 
pleted. The  handling  of  the  bill  will  proceed  upon  much  the 
same  lines  as  in  the  case  of  a  domestic  draft.  It  will  be  en- 
dorsed and  sent  with  the  bill  of  lading  and  insurance  cer- 
tificate to  a  correspondent  bank  in  England,  with  which  the 
New  York  banker  has  formed  an  agreement  covering  the  de- 
tails of  such  transactions.  Upon  its  arrival,  it  will  be  pre- 
sented to  the  drawee  for  acceptance,  after  which  it  may 
either  be  sold  in  the  discount  market  of  London,  or  held  as  an 
investment  until  maturity  by  the  correspondent  bank  under 
instructions  from  the  American  bank.  In  either  case  it  will 
sooner  or  later  produce  an  inflow  of  funds  into  the  bank  in 
England  to  be  credited  to  the  account  of  the  New  York  bank 
which  advanced  the  money  in  the  purchase  of  the  bill. 

If,  to  digress  for  a  moment,  the  New  York  banker  had 
taken  the  cotton  exporter's  bill  for  collection,  the  drawer 
would  have  been  required  to  wait  until  the  bill  had  matured 
and  had  been  redeemed  by  the  English  importer  before  its 
value  was  turned  over  to  him.  But  this  variation  of  detail 
would  not  greatly  change  the  future  history  of  the  bill;  it 
would  be  sent  to  England  for  acceptance  and  eventually  re- 
deemed by  the  importer,  at  which  time  the  funds  accruing 
from  the  collection,  paid  to  a  bank  in  England,  would  be 
delivered  by  the  New  York  bank  to  the  seller  of  the  cotton. 
After  the  transaction  had  been  cleared  up  for  both  merchants, 
regardless  of  whether  the  draft  was  originally  bought  or  taken 
for  collection,  and  regardless,  also,  of  whether  it  was  sold  in 
the  London  discount  market  or  held  by  the  correspondent  as 
an  investment,  there  w^ould  remain  an  uncancelled  creditor- 
debtor  relationship  between  the  New  York  banker  from  whom 
the  shipper  had  received  his  money  and  the  English  banker  to 
whom  the  importer  had  paid  his  draft.     This  simple  trans- 


NATURE  AND  USE  OF  BILLS  OF  EXCHANGE      15 

action  is  illustrative  of  the  method  by  which  payment  is  re- 
ceived for  most  of  our  immense  exports  and,  indeed,  for  the 
largest  part  of  the  exports  of  all  countries.  The  time  draft, 
drawn  for  sixty  or  ninety  days'  sight  by  the  exporter,  is  the 
typical  financing  instrument  in  international  trade. 

4.  Banking  relations  created  by  foreign  bills  of  exchange. 
In  the  preceding  illustration  the  transaction  in  foreign  ex- 
change was  left  at  the  point  where  a  payment  was  due  from 
the  London  banker  who  received  the  importer's  payment  to 
the  New  York  banker  who  purchased  the  exporter's  bill  of 
exchange.  It  is  apparent  that  by  advancing  money  against 
the  bills  of  exporters  and  sending  these  bills  forward  to  their 
respective  countries,  the  banks  of  America  are  virtually 
transferring  a  portion  of  their  funds  to  foreign  cities,  for  each 
purchase  of  a  bill  in  this  country  diminishes  the  cash  resources 
of  the  purchasing  banker,  while  each  collection  abroad  returns 
the  purchase  price  in  a  foreign  coinage  to  a  foreign  correspond- 
ent. Obviously  so  one-sided  a  transaction  could  not  long 
continue  without  driving  American  banks  engaged  in  foreign 
exchange  out  of  business,  for  no  banker  can  continue  opera- 
tions when  his  funds  are  held  in  foreign  money  centers. 

But  international  trade  is  not  a  one-sided  matter;  goods  are 
imported  as  well  as  exported,  and  the  business  men  of  all 
countries  have  payments  to  make  to  foreign  customers  as  well 
as  payments  to  receive  from  them.  If  we  assume  for  the 
moment  that  it  is  the  universal  practice  in  foreign  trade  for 
the  exporter  to  draw  upon  the  importer,  as  did  the  cotton  mer- 
chant in  our  hypothetical  example,  it  will  become  clear  that 
the  import  trade  of  the  United  States  must  set  up  a  current 
of  bills  which  gives  English  and  other  foreign  banks  credit 
with  banks  in  this  country  just  as  our  export  trade  gives 
American  banks  credits  abroad.  For  example,  an  English 
merchant  who  exports  china-ware  worth  two  thousand  pounds 
sterling  to  an  American  customer  would  draw  for  the  equiv- 
alent of  this  amount  in  dollars  and  cents  upon  the  buyer  and 
dispose  of  his  bill  to  his  bank  in  England.  The  draft  would  be 
forwarded  to  an  American  correspondent,  presented  to  the 
drawee,  and  eventually  redeemed,  at  which  time  the  proceeds 


16  FOREIGN  EXCHANGE 

wouKl  he  placed  to  the  credit  of  the  English  banker  who  first 
nc(iuire(l  the  draft.  If  the  same  pair  of  banks  should  happen 
to  handle  both  the  cotton  and  the  china  bills,  the  two  credits 
would  offset  each  other  and  the  accounts  of  the  bankers  as 
well  as  those  of  the  merchants  would  be  cleared.  The  iden- 
tity of  the  banks  concerned  in  the  two  transactions  is,  of 
course,  purely  accidental.  But  view  the  New  York  and 
London  markets  as  a  whole,  disregarding  the  individual 
bankers  who  compose  the  markets,  and  it  must  be  clear  that 
the  two  transactions  we  are  considering  will  create  equal  and 
offsetting  credits  in  the  two  markets.  Expand  the  illustra- 
tion to  include  the  whole  of  our  trade  with  Great  Britain  and 
it  will  appear  that  a  multitude  of  transactions  arising  out  of 
our  import  trade  are  continually  placing  the  New  York 
market  in  the  debt  of  London,  while  similar  transactions 
arising  from  our  export  trade  are  continually  reversing  this 
creditor-debtor  relationship.  Cancellations  of  offsetting 
debits  and  credits  are,  therefore,  constantly  in  process  be- 
tween the  two  markets  leaving  only  a  net  balance  —  small  in 
comparison  with  the  total  trade  —  to  be  paid  by  remittance 
from  one  city  to  the  other. 

The  process  of  clearing  the  accounts  of  the  bankers  by 
cancelling  debits  against  credits  appears  feasible  so  long  as 
the  foreign  trade  of  the  nation  is  financed  by  drafts  of  ex- 
porters against  importers.  We  have  now  to  extend  our  in- 
quiry to  include  other  ways  of  effecting  payment  by  means 
of  bills  of  exchange  and  to  see  that,  whatever  the  method  used, 
so  long  as  a  bill  of  exchange  is  employed  in  the  transaction, 
the  eflfect  upon  the  relationship  of  the  banks  will  be  the  same: 
the  export  trade  of  the  nation  will  create  for  its  banks  credits 
in  foreign  markets;  the  import  trade,  countervailing  debits 
which  may  be  offset  against  these  credits.  For  our  present 
purpose  it  is  not  necessary  to  examine  in  detail  the  different 
kinds  of  bills  of  exchange  which  arise  from  international  com- 
merce or  the  different  ways  in  which  these  bills  are  custom- 
arily handled  by  the  bankers ;  this  we  shall  do  in  later  chap- 
ters. Disregarding  differences  of  detail,  payment  in  inter- 
national trade  is  effected  by  means  of  bills  of  exchange  in 


NATURE  AND  USE  OF  BILLS  OF  EXCHANGE      17 

either  of  the  following  ways:  (a)  by  the  exporter's  order, 
drawn  upon  the  importer  or  his  banker  for  the  amount  due; 
(h)  by  remittance  from  the  importer  to  the  exporter  of  a  bill 
of  exchange  equal  in  value  to  the  amount  of  the  debt.  The 
former  of  these  methods  has  been  covered  in  the  preceding 
discussion ;  we  shall  now  see  that  the  use  of  the  second  method 
creates  precisely  the  same  creditor-debtor  relationships  be- 
tween the  banks,  as  does  the  use  of  the  first. 

Suppose  that  the  merchant  who  imports  china-ware  from 
England  has  agreed  to  terms  of  sale  which  require  a  remittance 
upon  arrival  of  the  goods.  How  will  this  remittance  be 
made  ?  The  importer  has  a  choice  of  two  alternatives :  he  may 
send  the  purchase  price  in  gold,  or  in  the  form  of  a  paper 
instrument  acceptable  to  the  exporter.  Of  these  alterna- 
tives, the  former  will  undoubtedly  be  avoided  if  possible  be- 
cause of  the  trouble  and  expense  involved  in  shipping  the 
gold;  the  importer  will  avail  himself  of  the  latter  if  an  ac- 
ceptable paper  instrument  can  be  obtained.  The  English 
exporter  will  require  only  that  the  instrument  be  of  such  form 
that  he  can  cash  it  at  his  bank,  and  this  requirement  will  be 
answered  by  a  banker's  demand  bill  of  exchange,  or  check, 
drawn  by  a  New  York  bank  against  a  bank  in  London.  Ac- 
cordingly, the  American  importer  goes  to  his  banker  and  by 
a  payment  in  dollars  and  cents  buys  a  demand  draft  for  two 
thousand  pounds  sterling  made  payable  to  himself  (the 
importer).  Endorsed  and  sent  to  the  English  exporter,  this 
draft  may  be  deposited  in  any  bank  in  England,  giving  the 
depositor  an  almost  immediate  credit  of  two  thousand 
pounds;  for  the  process  of  presenting  the  draft  for  encash- 
ment to  the  drawee-bank  in  London  will  consume  but  a  few 
hours  and  the  exporter's  banker  will  transmit  the  proceeds  to 
his  account.  This  form  of  remittance  is  entirely  acceptable 
to  both  merchants,  since  it  allows  each  to  make  or  receive  his 
payment  in  the  money  of  his  own  country  and  to  conduct  his 
transactions  with  his  own  banker. 

But  this  service  to  the  merchants  is  rendered  by  the  banks 
in  the  two  countries  only  because  they  are  willing  to  assume 
for  themselves  the  creditor-debtor  relationship  created  by 


18  FOREIGN  EXCHANGE 

the  sale  of  the  china;  for  after  both  importer  and  exporter  are 
freed  from  the  transaction,  the  New  York  hank  which  re- 
ceived the  import cr's  money  will  remain  in  the  debt  of  (he 
London  hank  which  honored  the  draft.  Clearly,  therefore, 
the  use  of  bills  of  exchange  in  making  payment  for  goods 
imported  into  this  country,  whether  the  bills  are  drawn  by 
the  foreign  exporters  or  bought  for  remittance  by  the  Amer- 
ican imj^orters,  will  have  the  effect  of  placing  American 
banks  in  the  debt  of  banks  in  foreign  comitries.  On  the  other 
hand,  the  bills  used  in  effecting  payment  for  our  exports, 
whether  they  take  the  one  form  or  the  other,  will  reverse  this 
relationship  and  place  foreign  banks  in  the  debt  of  American. 
5.  Clearing  the  accounts  of  the  bankers  in  foreign  ex- 
change. The  cancellation  of  offsetting  credits  which  results 
from  bankers'  transactions  in  foreign  exchange  must  not  be 
supposed  to  take  place  automatically,  or  even  intentionally. 
On  the  contrary,  each  of  the  many  bankers  who  engage  in  the 
business  seeks  a  personal  profit  from  his  operations,  and  buys 
and  sells  bills  of  exchange  with  this  profit  in  mind  and  not 
with  a  view  toward  the  ultimate  effect  upon  the  relationships 
of  the  different  markets  as  a  whole.  Nevertheless,  these 
normal,  profit-seeking  operations  of  a  multitude  of  individ- 
uals result  in  a  cancellation  of  offsetting  credits  and  a  clearing 
of  the  accounts  of  the  bankers  so  far  as  possible  without  the 
shipment  of  gold  from  one  market  to  the  other.  To  make 
this  result  clear,  let  us  focus  our  attention  upon  the  case  of  a 
typical  dealer  in  foreign  exchange  operating  in  the  New  York 
market.  This  individual  engages  principally  in  two  sets  of 
transactions.  The  first  of  these  is  the  buying  of  exporters' 
bills  of  exchange  drawn  upon  the  different  markets  of  the 
world  and  the  forwarding  of  these  bills  for  acceptance  and 
discount  (or  for  collection)  to  foreign  correspondents.  This 
group  of  operations,  as  we  have  seen,  creates  for  him  supplies 
of  funds  in  the  different  foreign  cities  where  the  bills  are  pay- 
able. The  second  set  of  transactions  is  concerned  with 
utilizing  these  funds  by  drawing  his  own  drafts  against  the 
balances  held  by  his  foreign  correspondents  and  selling  them 
in  his  market  to  those  who  have  remittances  to  make.     His 


NATURE  AND  USE  OF  BILLS  OF  EXCHANGE      19 

business  is,  of  course,  conducted  on  an  immense  scale  and  is 
concerned  with  a  multitude  of  bills  of  every  denomination  and 
tenor;  for  each  season  brings  a  flood  of  bills  into  the  New 
York  market  —  bills  drawn  against  our  exports  of  food,  cotton, 
machinery,  copper,  and  other  goods  to  the  various  markets 
of  the  world  —  and  a  constantly  recurring  demand  for  the 
banker's  drafts  from  the  importers  of  manufactured  goods 
from  Europe,  or  coffee  from  Brazil,  or  silk  and  jute  from  the 
Orient,  or  fruits  and  spices  from  tropical  countries.  Engaged 
in  these  two  groups  of  transactions,  our  New  York  banker 
will,  by  one  series  of  operations,  constantly  build  up  credits 
in  London,  Paris,  Buenos  Aires,  and  other  foreign  centers, 
and  by  the  second  series  continually  destroy  these  credits. 
Now,  the  profit  of  this  typical  banker  depends  upon  his 
avoiding,  on  the  one  hand,  the  creation  of  foreign  credits  in 
excess  of  his  ability  to  use  them,  and,  on  the  other,  taking  care 
not  to  find  himself  without  a  balance  in  a  particular  foreign 
center  when  a  brisk  demand  for  bankers'  bills  drawn  upon 
this  center  arises.  He  must  neither  buy  commercial  bills 
much  in  excess  of  the  demand  for  his  own  drafts  against  the 
same  markets,  nor  fail  to  buy  a  sufficient  quantity  of  these 
bills  to  meet  a  profitable  demand  for  his  own  drafts.  For 
his  profit  is  drawn  from  a  difference  in  his  favor  between  the 
rates  of  exchange  at  which  he  buys  and  sells,  and  this  profit 
cannot  be  gained  from  buying  only,  nor  from  selling  only,  but 
rather  from  a  combination  of  purchase  and  sale.  Left  to  his 
own  devices,  therefore,  the  banker's  self-interest  will  impel 
him  to  clear  his  account  with  his  foreign  correspondents 
within  periods  as  short  as  possible,  else  he  must  either  find 
himself  with  idle  funds  lying  in  foreign  cities  or  be  compelled 
to  forego  opportunities  to  sell  demand  drafts  at  favorable 
rates  because  of  a  lack  of  these  funds.  A  cardinal  rule  of  his 
business  will  })e  the  rule  of  compensating  purchase  and  sale,  or 
the  maintenance  of  an  equilil)rium  between  the  additions  to, 
and  subtractions  from,  his  foreign  balance.*    No  overseeuig 

'  This  practice  of  offsotling  purchases  of  foreign  bills  by  sales  of  foroipn 
bills  is  a  pui'lin;'  princii)Ie  of  regular  dealers  in  exchange,  but  it  must  not  he 
understood  that  no  exceptions  to  the  practice  are  to  be  found.  Moreover,  the 


80  FOREIGN  EXCHANGE 

of  his  transactions  will  be  necessary  to  induce  him  to  obey 
this  rule  within  practicable  limits,  for  his  own  self-interest 
will  take  care  of  that.  Similar  conditions  will  govern  the 
operations  of  all  other  regular  dealers  in  foreign  exchange  in 
New  York  and  in  the  other  markets  of  the  world.  Though 
not  actuated  by  the  purpose  of  clearing  the  accounts  of  all 
the  banks  as  between  the  markets  as  a  whole,  nevertheless, 
each  dealer  will  strive  to  keep  his  own  relations  with  his 
foreign  correspondents  as  free  from  excess  credits  as  possible 
and  the  aggregate  effect  of  their  individual  operations  will  be 
to  clear  the  accounts  of  the  markets. 

If  the  typical  dealer  whose  case  we  have  been  considering 
should  find  that  he  has  been  buying  more  sterling  bills  than 
he  can  utilize  through  the  sale  of  his  own  sterling  demand 
drafts  to  his  business  clientele,  and  that,  consequently,  his 
balance  in  London  is  growing  disproportionately  large,  he  will 
attempt  to  sell  demand  drafts  to  other  bankers  in  the  New 
York  market  whose  relation  to  London  is  the  reverse  of  his 
own.  This  action  will  be  tantamount  to  sharing  his  London 
credit  with  other  bankers  whose  opportunities  to  sell  sterling 
bills  to  the  business  world  are  larger  than  his  own.  Thus  the 
aggregate  sterling  credit  of  the  New  York  market  will  be 
apportioned  among  the  banks  of  New  York,  until  the  demand 
of  the  market  for  sterling  drafts  is  satisfied;  or,  in  other  words, 
until  all  possible  opportunities  for  cancelling  these  credits 
against  corresponding  debits  have  been  exploited.  The  same 
process  will  govern  the  dealings  of  the  New  York  market  in 
the  bills  of  exchange  of  other  countries,  and  the  net  result  will 
be  a  clearing  of  all  accounts  so  far  as  clearance  is  possible. 

statement  does  not  imply  that  dealers  in  exchange  do  not  habitually  carry 
balances  to  their  credit  in  foreign  centers,  but  only  that  they  attempt  to 
maintain  these  balances  at  a  constant  figure  by  offsetting  credits  and  debits. 

Two  kinds  of  operations  in  foreign  exchange  are  carrier!  on  by  bankers  at 
times,  both  of  which  require  a  surrender  of  the  principle  of  equal  purchase  and 
sale.  These  are:  first,  speculation  in  foreign  bills;  and,  secondly,  investment  in 
foreign  bills.  The  condition  of  the  exchange  market  which  encourages  these 
operations  on  the  part  of  the  bankers  will  be  discussed  at  length  in  later  chap- 
ters. IJul  it  n^.ay  be  said  here  that,  in  the  common  run  of  his  transactions,  and 
in  all  cases  wlien  he  is  acting  solely  on  behalf  of  the  seller  or  buyer  of  bills  of 
exchange,  tlie  banker  will  govern  his  activities  by  the  principle  of  compen- 
sating purchase  and  sale. 


CHAPTER  II 

DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE 

Our  discussion  in  the  preceding  chapter  was  purposely 
limited  to  those  bills  of  exchange  which  arise  from  the  world's 
trade  in  commodities,  whose  function  is  to  facilitate  pay- 
ment of  money  owed  by  the  buyer  to  the  seller  of  the  goods. 
Though  this  is  by  far  the  chief  use  of  foreign  bills  of  exchange, 
many  other  transactions  between  individuals  of  different 
countries  are  constantly  occurring  to  make  a  payment  of 
money  from  one  to  the  other  either  necessary  or  desirable. 
In  all  such  cases  there  is  opportunity  to  effect  payment  by 
the  use  of  bills  of  exchange.  The  great  current  of  bills  which 
flows  between  the  money  centers  of  the  world  is  engaged  in 
clearing  up  millions  of  such  payments,  various  in  their  origin 
and  in  their  terms,  between  the  citizens  of  the  different  na- 
tions; and  the  bankers  of  the  money  centers  through  whose 
hands  these  bills  pass  are  engaged  continually  in  buying  the 
drafts  of  creditors  upon  their  foreign  debtors,  and  selling  to 
debtors  their  own  demand  drafts  for  remittance  to  foreign 
creditors.  Each  exchange  dealer  attempts  to  bring  his  pur- 
chases and  sales  as  nearly  as  possible  into  equilibrium,  thereby 
reducing  to  the  minimum  the  balance  due  between  himself 
and  his  foreign  correspondents.  WTien  this  end  can  be 
achieved,  the  accounts  of  the  different  countries  —  including 
those  of  the  bankers  as  well  as  those  of  the  merchants  —  can 
be  cleared  without  the  actual  transfer  of  money  from  one 
country  to  another.  It  is  apparent,  however,  that  this  desir- 
able result  will  come  about  only  if  the  supply  of  bills  offered 
for  sale  to  all  the  bankers  of  each  money  center  is  roughly  off- 
set by  the  demand  for  bills  from  these  bankers;  for  only  under 
this  assumption  will  it  be  possible  for  each  dealer  to  balance 
his  sales  against  his  purchases  and  utilize  all  of  his  credits  in 
foreign  cities.     It  is  the  purpose  of  the  present  chapter  to 


a  FOREIGN  EXCHANGE 

inquire  how  far  this  equilibrium  of  supply  and  demand  in  the 
exchange  market  is  possible,  and  what  effects  will  be  produced 
by  it. 

6.  Sources  of  demand  and  supply  of  bills  of  exchange. 
IiiternatioiKil  transactions  in  which  bills  of  exchange  are 
employed  fall  into  the  following  principal  groups: 

(a)  International  trade  in  commodities. 

(b)  International  purchase  of  services. 

(c)  International  trade  in  securities. 

(d)  International  payments  of  interest  and  principal  due 
upon  securities  held  by  foreign  investors. 

(e)  International  remittances  for  the  use  of  travelers  and 
foreign  residents,  by  immigrants  to  their  families  and 
friends,  and  by  governments  for  the  support  of  their 
foreign  representatives. 

(J)  International  transfer  of  liquid  capital  from  banks  in 
one  financial  center  to  those  in  another. 

The  first  of  these  groups  has  already  been  discussed.  We 
have  seen  that  our  export  trade  creates  a  supply  either  of 
commercial  bills  drawn  by  our  merchants  upon  their  foreign 
customers,  or  of  bankers'  bills  to  be  received  by  our  merchants 
from  their  foreign  customers  and  cashed  at  our  banks.  The 
negotiation  of  both  types  of  bills  has  the  effect  of  transferring 
funds  from  our  banks  to  those  of  foreign  cities.  On  the  other 
hand,  our  import  trade  either  creates  a  demand  for  bankers' 
bills  to  be  remitted  by  our  merchants  to  foreign  exporters;  or 
else  a  supply  of  commercial  bills  drawn  by  foreign  exporters, 
which  bills,  received  by  our  banks  from  their  foreign  corre- 
spondents, are  redeemed  by  our  merchants  at  the  offices  of  our 
bankers.  Both  modes  of  payment  will  cause  a  transfer  of 
funds,  the  property  of  foreign  bankers,  into  the  banks  of  our 
country.  The  effect  of  our  international  trade  in  goods  may 
therefore  be  summed  up  in  a  brief  formula:  our  exports 
create  foreign  credits  for  oui  banks;  our  imports  create 
similar  credits  in  our  country  for  foreign  banks. 

7.  International  purchase  of  services.  Two  forms  of  serv- 
ice, generally  speaking,  command  an  international  market: 
the  transportation  of  freight  upon  the  seas,  and  the  work 


DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE    23 

done  by  bankers  and  financing  houses.  When  American 
business  men  purchase  these,  or  other,  kinds  of  service  from 
foreigners,  the  effect  upon  the  exchange  market  is  the  same 
as  if  these  Americans  had  imported  goods. 

For  the  past  half-century,  goods  entering  or  leaving 
American  ports  have  been  carried  chiefly  in  ships  of  foreign 
register,  and  American  traders  have  been  under  the  neces- 
sity of  paying  foreign  shipowners  large  amounts  yearly  on 
account  of  freight  charges.  Since  the  principal  foreign 
marine  companies  maintain  offices  in  the  seaport  cities  of  the 
United  States,  it  has  been  the  practice  of  our  merchants  to 
pay  their  freight  bills  at  these  local  offices;  but  money  thus 
collected  must  eventually  be  transferred  from  the  branch  to 
the  home  office,  and  the  most  convenient  method  of  transfer 
has  been  the  purchase  and  remittance  of  bankers'  demand 
drafts.  Thus  the  final  clearing  up  of  our  obligations  arising 
from  the  employment  of  foreign  freight  vessels  has  in  the  past 
given  our  bankers  opportunity  to  draw  their  bills  of  exchange 
against  credits  provided  for  them  in  foreign  cities  by  their 
purchase  of  the  commercial  bills  of  our  exporters.  The 
changes  which  have  taken  place  during  the  Great  War,  how- 
ever, have  left  the  United  States  in  possession  of  a  merchant 
marine  which  ranks  second  in  size  among  the  freight  carriers 
of  the  world.  If  this  marine  remains  permanently  under 
our  ownership,  our  former  demand  for  bills  of  exchange 
with  which  to  pay  for  freight  service  will  to  a  great  extent 
disappear. 

For  reasons  which  will  be  discussed  in  a  later  chapter,  Lon- 
don has,  in  the  past,  been  the  center  of  the  world's  business 
in  foreign  exchange,  and  because  of  their  strategic  position, 
London  bankers  have  earned  large  amounts  yearly  in  the 
form  of  commissions  on  transactions  performed  on  behalf  of 
bankers  in  other  financial  centers.  The  New  York  bankers, 
for  example,  have  engaged  more  of  this  kind  of  service  from 
banks  and  finance  houses  in  London  than  they  could  ofl'sct 
by  reciprocal  services.  Thus,  at  the  end  of  each  accounting 
period  a  balance  has  been  due  these  London  bankers  on  the 
score  of  commissions  earned,  which  balance,  if  the  accounts 


24  FOREIGN  EXCHANGE 

of  the  two  sots  of  banks  had  otherwise  been  cleared  of  debits 
and  credits,  has  required  a  remittance  of  sterUng  bills.  This 
form  of  service,  then,  has  had  an  effect  upon  the  exchange 
market  of  New  York  similar  to  that  of  marine  transportation; 
tliat  is,  it  has  absorbed  a  part  of  the  supply  of  bankers'  bills 
drawn  aj^ainst  the  foreign  credits  created  by  our  export  trade. 
The  spread  of  American  branch  banks  in  foreign  countries 
and  the  increasing  importance  of  New  York  as  an  inter- 
national money  center,  both  products  in  large  part  of  the 
Great  War,  will  tend  to  reduce  this  demand  for  bankers* 
bills  in  the  future. 

8.  International  trade  in  securities.  When  American 
stocks  and  bonds  are  sold  abroad,  the  terms  of  sale  ordinarily 
provide  for  draft  upon  the  buyer  drawn  by  the  seller,  the 
securities  to  be  delivered  upon  payment  of  the  draft.  Thus 
a  bond  house  or  underwriting  syndicate  in  New  York  which 
sells  a  block  of  stocks  to  an  English  investor  will  draw  a  sight 
draft  for  the  amount  of  the  sale.  This  bill  of  exchange  will 
be  sold  in  the  New  York  market  to  a  banker  who  also  takes 
possession  of  the  stocks  as  additional  security  in  the  trans- 
action. The  draft,  endorsed  to  the  London  correspondent, 
is  pinned  to  the  securities  and  forwarded;  upon  its  arrival  in 
London,  notice  will  be  given  the  investor  that  he  may  obtain 
possession  of  his  stocks  upon  payment  of  the  draft,  and  when 
payment  has  been  made  the  transaction  will  leave  the  two 
banks  in  precisely  the  same  creditor-debtor  relationship  as 
that  produced  by  our  exports  of  merchandise. 

Before  the  Great  War,  the  annual  investment  of  foreign 
capital  in  American  industries  gave  rise  to  a  large  volume 
of  such  bills  of  exchange.  It  had  become  the  practice  of 
European  finance  houses  to  participate  in  underwriting  syn- 
dicates formed  in  New  York  to  float  new  issues  of  American 
companies,  the  purpose  of  the  foreign  financiers  being  to  with- 
draw a  portion  of  the  issue  from  the  American  investment 
market  and  sell  it  among  their  own  clients  abroad.  At  the 
same  time  American  bond  houses  were  seeking  independently 
to  develop  a  market  for  our  securities  among  foreign  in- 
vestors and  succeeding  in  selling  abroad  yearly  an  aggregate 


DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE    25 

of  large  value.  In  1910,  according  to  the  estimate  of  an 
eminent  English  authority,  the  value  of  English  investments 
alone  in  American  industries  was  more  than  three  billion 
dollars,  and  annual  additions  to  this  investment  were  amount- 
ing to  scores  of  millions.  This  immense  traffic  in  American 
securities  has  added  greatly  to  the  supply  of  bills  of  exchange 
on  our  market.  Since  1914,  however,  the  investment  of 
European  capital  in  American  industries  has  been  negligible, 
and  international  trade  in  securities  has  accordingly  ceased 
to  affect  our  exchange  market  on  the  supply  side. 

Obviously,  the  purchase  by  Americans  of  foreign  securities 
will  affect  the  market  for  foreign  exchange  in  a  manner  the 
reverse  of  that  just  discussed.  Payment  in  this  case  will  be 
effected  by  draft  drawn  upon  the  American  buyer  by  the 
foreign  seller  of  the  stocks  or  bonds,  or  by  remittance  of 
bankers'  demand  drafts  from  this  side,  either  of  which  methods 
of  payment  will  place  American  banks  in  the  debt  of  foreign 
by  causing  an  inflow  of  funds  here  for  the  account  of  the 
banks  abroad  from  whom  the  foreign  seller  receives  his 
money.  The  customary  procedure  when  placing  a  foreign 
issue  of  securities  upon  the  American  market  is  somewhat  as 
follows:  The  services  of  an  American  banking  firm  are  en- 
gaged for  the  purpose  of  underwriting  and  managing  the  sale; 
individual  purchasers  of  the  bonds  and  stocks  pay  this  firm 
in  dollars  for  the  value  of  the  securities  they  buy;  and  when 
the  entire  issue  has  been  disposed  of,  the  American  bankers 
are  in  possession  of  a  sum  of  money  belonging  to  some  corpo- 
ration or  business  firm  in  a  foreign  country.  Bankers'  demand 
drafts  may  now  be  })ought  and  sent  abroad  to  transfer  this 
money  to  its  real  owners;  or,  if  it  is  the  intention  of  the  com- 
pany issuing  the  securities  to  invest  the  proceeds  in  American 
goods,  the  money  in  the  hands  of  the  underwriting  syndicate 
will  be  used  to  buy  up  the  bills  of  exchange  drawn  by  the 
exporters  of  these  goods  against  the  foreign  company.  In 
either  case,  when  carried  through  to  its  conclusion,  the  sale 
of  foreign  securities  to  AmcricaJi  investors  will  have  rcsulled 
in  an  increase  in  the  demand  for  some  kind  of  foreign  ex- 
change in  our  market. 


26  FOREIGN  EXCHANGE 

Heforc  101  K  in  vestment  opportunities  in  the  United  States 
were  so  attractive  that  httlc  American  capital  sought  a 
foreiizn  market;  l)ut  during  tlie  war  we  departed  from  our 
normal  practice  and  loaned  billions  of  dollars  to  foreign  gov- 
ernments. The  whole  of  this  vast  sum  was  brought  to  bear 
upon  our  exchange  market  from  the  demand  side  in  the 
manner  discussed  in  the  preceding  paragraph,  since  the  pro- 
ceeds were  used  to  finance  our  sales  of  munitions,  foodstuffs, 
and  other  materials  to  the  belligerent  nations  by  taking  up  the 
bills  of  exchange  drawn  against  these  shipments  by  our 
merchants.  During  this  period  our  exports  of  goods  greatly 
exceeded  our  imports,  and  as  a  result  the  supply  of  commer- 
cial bills  offered  for  sale  to  our  bankers  vastly  outweighed  the 
demand  of  our  importers  for  the  drafts  with  which  the 
bankers  sought  to  offset  their  purchases  of  exporters'  bills. 
AVithout  some  compensating  factor  on  the  demand  side  of  the 
market,  our  exporters  would  have  experienced  great  difficulty 
in  disposing  of  their  bills  of  exchange;  this  compensating 
factor  was  supplied  by  our  immense  loans  to  the  Allied  Gov- 
ernments, It  may  be  said  of  these  loans,  therefore,  that  be- 
cause our  Government,  or  its  citizens,  invested  in  foreign 
bonds,  there  resulted  a  demand  for  the  commercial  bills  of 
exchange  of  certain  other  Americans  which  would  not  other- 
wise have  existed.  Since  the  war  the  favorable  rates  of  ex- 
change have  encouraged  a  continuance  of  this  form  of  invest- 
ment in  foreign  countries  and  have  kept  alive  the  demand  for 
foreign  exchange  in  our  market  in  the  face  of  a  continuing 
preponderance  of  exports  over  imports. 

^yhen  securities  owned  abroad  are  either  redeemed  at 
maturity  or  resold  by  their  owners  to  the  country  which 
issued  them,  the  effect  upon  the  exchange  market  is  the 
opposite  of  that  caused  by  the  original  sale.  Suppose,  for 
example,  that  American  railway  bonds  worth  $10,000  come 
to  maturity  in  the  hands  of  an  English  investor  and  that  the 
transaction  of  redeeming  them  is  handled  by  the  financial 
agents  of  the  road  —  let  us  say  by  some  Trust  Company  in 
New  York.  The  redemption  money  will  be  deposited  with 
the  Trust  Company,  converted  into  sterling  demand  bills,  and 


DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE    27 

sent  over  to  a  London  correspondent.  The  English  investor 
will  then  be  notified  to  surrender  his  bonds  to  this  London 
l)ank  and  receive  the  money  due  him,  the  bank  having 
placed  itself  in  funds  to  meet  this  expense  by  cashing  the 
demand  drafts  received  from  New  York.  Maturities  of  this 
kind  are  frequently  offset  by  refunding  operations  or  by  the 
sale  of  new  securities  to  the  foreign  capitalist  whose  invest- 
ment has  reached  its  term ;  but  if  in  a  given  year  more  Amer- 
ican securities  mature  in  the  hands  of  foreign  owners  than  are 
replaced  by  new  issues,  the  net  result  will  be  a  demand  for 
foreign  exchange  in  the  American  market.  The  same  effect 
will  follow  the  resale  to  America  of  American  securities  owned 
abroad.  Such  a  selling  movement  attained  vast  proportions 
during  the  Great  War  when  it  was  so  essential  for  foreign 
peoples  and  governments  to  establish  credits  in  New  York; 
the  effect  of  this  movement  was  to  increase  the  demand  for 
foreign  exchange  in  our  market.  Conversely,  when  foreign 
securities  owned  by  the  Government,  or  by  private  investors, 
of  the  United  States  mature  or  are  resold  abroad,  the  trans- 
actions will  create  a  supply  of  foreign  exchange  here  by  re- 
versing the  series  of  operations  just  discussed. 

There  is  a  floating  supply  of  standard  stocks  and  bonds 
which  appears  for  sale  upon  the  stock  exchanges,  first  of  one 
country,  then  of  another,  and  so  exerts  a  varymg  influence 
upon  the  supply  of  and  demand  for  bills  of  exchange.  Stock 
brokers  dealing  in  these  securities  keep  close  watch  upon  the 
quotations  of  the  different  exchanges,  alert  to  buy  in  the 
chea])er  and  sell  in  the  dearer  market,  thus  influencing  the 
balances  due  between  the  finance  houses  of  the  dift'erent 
centers.  When,  for  example,  some  such  stock  is  quoted  a 
point  lower  in  London  than  in  New  York,  a  brokerage  house 
in  New  York  which  has  London  connections  can  buy  a  thou- 
sand shares  on  the  London  Exchange  and  sell  them  almost 
simultaneously  on  the  exchange  in  New  York,  thus  making 
considerable  profit.  Obviously,  this  transaction  will  call  for 
a  remittance  of  funds  from  the  New  York  brokers  to  their 
London  associates,  and  so  create  a  demand  for  sterling  bills 
in  New  York. 


28  FOREIGN  EXCHANGE 

So  alcrl  arc  tlic  arhilragcurs  that  a  great  discrepancy  in  the 
qnotations  of  a  standard  stock  on  two  exchanges  can  hardly 
occur,  for  the  sHghlcst  divergence  produces  active  buying  and 
selling  which  soon  corrects  the  discre})ancy.  This  shifting  of 
ownership  in  securities  from  one  country  to  another  often 
exerts  an  unforeseen  influence  upon  the  foreign  exchange 
markets  of  the  world.  Because  of  the  great  amount  of 
ITnitcil  States  securities  owned  abroad,  the  New  York 
market  in  times  past  has  been  subjected  to  sudden  and  violent 
increases  in  demand  for  foreign  bills  of  exchange  due  to  the 
resale  of  these  securities  on  the  Stock  Exchange  of  New  York. 
Any  widespread  desire  on  the  part  of  foreign  investors  to  re- 
lease funds  which  they  have  invested  here  has  brought  these 
stocks  and  bonds  home  to  our  market  in  large  volume  and 
American  bankers  and  brokers  have  been  placed  under  the 
necessity  of  remitting  the  proceeds  of  their  sale  in  the  form 
of  bills  of  exchange.  These  selling  movements  usually  oc- 
curred when  there  was  distrust  abroad  concerning  the  sta- 
bility of  our  financial  and  industrial  structure;  thus  a  threat 
of  panic  in  America  has  been  certain  to  increase  the  demand 
for  foreign  exchange  in  New  York  through  the  medium  of  our 
stock  markets.  The  closing  of  the  New  York  Stock  Ex- 
change shortly  after  the  outbreak  of  the  Great  War  was  a 
precautionary  measure  intended  to  forestall  a  dangerous  sell- 
ing movement  of  this  origin. 

The  influence  of  international  trading  in  securities  upon  the 
demand  and  supply  of  bills  of  exchange  may  be  summarized 
as  follow^s:  The  sale  to  foreign  investors  of  securities  from 
America,  or  the  redemption  by  foreign  companies  of  their 
securities  owned  here,  causes  a  supply  of  bills  of  exchange  in 
our  market;  the  purchase  by  American  investors  of  securities 
from  abroad,  or  the  redemption  by  American  companies  of 
their  securities  owned  abroad,  causes  a  demand  for  bills  of 
exchange  in  our  market.  It  should  be  made  clear,  however, 
that  the  exchange  market  is  not  affected  in  one  way  or  the 
other  by  the  aggregate  of  these  foreign  investments  out- 
Standing  at  any  one  time,  but  only  by  current  additions  to, 
or  subtractions  from,  this  aggregate.    The  ten  billion  dollars 


DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE    29 

owed  by  foreign  governments  to  our  own  does  not  now,  so  far 
as  the  principal  of  the  debt  is  concerned,  exert  any  influence 
upon  the  exchange  market;  its  effect  was  felt  on  the  demand 
side  of  the  market  when  the  loans  were  made,  and  its  influ- 
ence upon  the  supply  side  of  the  market  will  be  felt  when 
the  principal  of  the  debt  is  repaid  to  our  country. 

9.  International  pajnnents  of  interest  and  dividends.  This 
is  a  secondary  influence  of  trading  in  securities.  These  pay- 
ments have  the  effect  of  increasing  the  demand  for  foreign 
bills  when  interest  payments  are  being  made  by  domestic 
companies  to  foreign  investors,  and  the  supply  of  bills  when 
the  payment  is  the  other  way.  The  actual  process  of  handling 
these  remittances  may  vary  as  between  different  transactions 
without  altering  their  effect  upon  the  exchange  market. 

For  example,  American  companies  which  have  a  large 
number  of  stock  and  bondholders  in  England  frequently  em- 
ploy a  firm  of  London  bankers  to  perform  what  is  known  as 
service  of  loan  —  that  is,  the  redemption  of  interest  coupons 
and  the  payment  of  declared  dividends  to  stockholders  of 
record.  Let  us  suppose  that  a  dividend  is  due  upon  a  pre- 
ferred stock  of  an  American  company  and  that  some  millions 
of  dollars  must  be  paid  to  English  stockholders.  These 
stockliolders  will  be  instructed  to  present  their  claims  to 
the  designated  London  house  which  is  performing  the  serv- 
ice of  loan,  where  they  will  be  redeemed  out  of  funds  sup- 
plied by  the  company.  Demand  for  sterling  bills  in  New 
York  will  appear  at  the  time  the  company  remits  these  funds 
through  their  financial  representative  on  this  side.  Similar 
payments  made  to  American  investors  by  foreign  companies 
will  have  a  reverse  effect  upon  the  market  for  foreign  ex- 
change in  our  country.  For  example,  when  the  Allied  Gov- 
ernments pay  interest  upon  the  bonds  held  by  the  United 
States,  they  will  be  compelled  to  place  funds  in  this  country 
to  the  amount  of  the  payments  due,  and  this  they  can  do 
either  by  buying  up  bills  drawn  on  American  houses  for 
remittance  to  our  treasury,  or  by  instructing  our  treasury  to 
draw  against  deposits  made  by  them  in  banks  of  their  own 
countries.     Either  process  will  increase  the  foreign  credits  of 


so  FOREIGN  EXCHANGE 

our  hanks.  For  a  long  time  to  come,  because  of  the  enormous 
liolilings  of  these  bonds  in  America,  current  interest  payments 
must  operate  as  an  appreciable  force  upon  the  supply  side  of 
our  excha litre  market. 

10.  Travelers'  expenditures,  immigrants'  remittances,  and 
the  like  create  a  demand  in  the  country  from  which  the  remit- 
tances are  made  for  the  exchange  of  the  country  in  which  the 
money  is  spent.  The  xVmerican  tourist  usually  supplies  him- 
self with  funds  before  his  departure  by  purchase  of  some  form 
of  bills  of  exchange  —  travelers'  letter  of  credit  or  travelers' 
checks  —  from  his  banker;  these  he  either  cashes  at  the  bank- 
ing offices  of  foreign  correspondents  or  transfers  to  hotel- 
keepers  and  others,  by  whom  they  are  cashed.  The  effect  of 
such  transactions  is  similar  to  that  of  remittances  of  bankers' 
demand  drafts  by  our  importers  of  foreign  goods;  that  is,  ex- 
change dealers  in  this  country  are  given  the  opportunity  to 
draw  against  their  credits  in  foreign  cities.  Similar,  also,  is 
the  effect  of  the  remittances  of  immigrants  whether  these  be 
made  by  postal  money  order  or  by  bankers'  demand  draft. 
A  postal  money  order  bought  by  an  Italian  in  New  York  and 
cashed  by  his  relative  in  Naples,  puts  the  United  States  Post- 
Office  in  the  debt  of  the  Italian.  Eventually  the  balance  due 
between  the  Governments  on  this  account  must  be  cleared  up 
by  remittance  from  this  side.  If  the  Italian  immigrant  had 
sent  his  money  through  an  Italian  banker  in  New  York,  the 
effect  upon  the  exchange  market  would  have  been  more  direct, 
but  not  other\\ase  different.  The  banker  in  New  York  would 
have  received  the  immigrant's  money,  his  correspondent  in 
Naples  would  have  turned  it  over  to  the  payee  of  the  draft, 
and  the  transaction  would  have  left  the  two  banks  in  the  same 
creditor-debtor  relationship  created  whenever  one  bank  sells 
bills  of  exchange  drawn  upon  another. 

The  maintenance  of  diplomatic  and  consular  ser\nces  by  our 
Government  calls  for  the  remittance  of  funds  for  the  pay- 
ment of  salaries,  rents,  and  other  expenses.  The  amount  of 
these  remittances,  though  small  relatively  to  the  other  forms 
of  international  payment,  makes  up  in  the  aggregate  a  large 
absolute  sum.  In  transferring  funds  abroad  for  this  purpose. 


DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE    31 

the  medium  usually  employed  is  a  draft  or  order  which,  pur- 
chased on  this  side,  will  be  redeemed  in  a  foreign  city.  The 
fact  that  these  funds  are  transferred  on  Government  account 
in  no  wise  differentiates  their  effect  upon  the  exchange  mar- 
ket; indeed,  if  the  Government  were  to  pay  its  expenses  in 
foreign  countries  in  Federal  Reserve  Notes  or  Gold  Certifi- 
cates, this  mode  of  payment  would  none  the  less  have  the 
same  effect  as  a  demand  for  bills  of  exchange  in  our  market. 
Paper  money  of  this  kind,  lacking  currency  abroad,  would 
collect  in  foreign  banks  and  be  sent  back  to  New  York  for 
deposit  wath  American  correspondents  of  these  banks.  These 
credits  would  offset  our  bankers'  balances  in  foreign  countries 
precisely  as  if  our  Government  had  paid  the  money  over  to 
our  banks  in  the  first  instance  and  received  bankers'  demand 
bills  for  remittance  abroad. 

II.  Short-term  loans  between  financial  centers.  There 
is  in  every  financial  center  a  varying  amount  of  liquid  capital 
employed  solely  in  short-term  loans.  It  happens  at  times 
that  opportunities  for  profitable  employment  of  these  loan 
funds  in  the  local  market  fall  behind  those  offered  by  foreign 
financial  centers.  When  this  is  the  case,  bankers  in  the  two 
centers  will  shift  a  portion  of  this  liquid  capital  from  the 
poorer  market  to  the  better,  effecting  this  transfer  by  draft 
drawn  by  the  banker  in  the  borrowing  market  upon  the 
banker  in  the  lending  market.  There  are  some  technical 
features  of  the  bills  drawn  in  the  course  of  these  lending 
operations  which  distinguish  them  from  other  bills  suffi- 
ciently to  warrant  the  close  and  detailed  examination  which 
we  shall  give  them  in  a  later  chapter;  but  since  the  effect  of 
these  bills  upon  the  exchange  market  is  the  same,  whatever 
their  technical  nature,  we  may  in  the  present  discussion  con- 
sider them  uniform. 

To  illustrate,  suppose  the  discount  rate  in  New  York  rises 
sufficiently  above  that  in  London  to  attract  loan  funds  from 
the  latter  market.  New  York  bankers  will  then,  by  agree- 
ment, draw  sterling  bills  at  sixty  or  ninety  days'  sight  upon 
banks  in  London  and  sell  them  for  dollars  in  New  York. 
These  bills  will  be  sent  over  by  the  buyer  and  presented  for 


85  FOREIGN  EXCHANGE 

accoi>tanco  to  the  London  banks  upon  whicli  they  are  drawn, 
after  which  tlicy  will  he  sold  in  the  T>ondon  discount  market, 
thus  ahsorhiiii:  a  portion  of  the  credit  of  that  market.  In 
New  York,  the  drawini;  hanker  will  be  in  possession  of  funds 
which  he  may  lend  at  the  higher  rate  of  interest  prevailing 
here.  When  the  bill  matures  in  London,  the  loan  may  be 
extended  by  a  rei)etition  of  the  operation,  thus  creating  a 
second  sterling  bill  whose  proceeds  when  sold  in  the  London 
discount  market  will  supply  the  funds  for  redeeming  the 
original  bill.  Or,  if  the  opportunity  for  profit  has  disappeared, 
the  transaction  may  be  closed  out  and  the  profit  divided 
between  the  two  bankers  according  to  agreement  previously 
made.  In  the  latter  case,  the  loan  is  withdrawn  by  the  New 
York  banker's  buying  sterhng  exchange  in  the  market  and 
sending  it  to  his  London  correspondent  in  time  to  meet  the 
maturing  draft  which  originated  the  lending  operation. 
Thus,  when  New  York  is  borrowing  on  short  term  from  Lon- 
don or  other  foreign  centers,  a  supply  of  exchange  is  created 
in  our  market;  when  the  loan  is  withdrawn,  or  when  New 
York  is  lending  in  foreign  centers,  a  demand  for  bills  of  ex- 
change appears  in  our  market.  In  the  past,  New  York, 
though  borrownng  frequently  and  in  large  amounts  from 
foreign  cities,  has  rarely  loaned  abroad,  since  the  discount 
rate  in  New  York  has  rarely  fallen  below  foreign  money  rates. 

12.  Summary  of  demand  and  supply  factors  of  the  exchange 
market.  In  summary  it  may  be  said  that  the  supply  of  bills 
of  exchange  offered  to  dealers  on  the  New  York  market 
comes  principally  from  the  following  sources: 

(a)  The  exportation  of  American  goods. 

(6)  The  sale  of  American  securities  to  foreign  investors. 

(c)  The  payment  of  interest  and  dividends  on  foreign 
securities  owned  here. 

(d)  The  contracting  by  New  York  bankers  of  short-term 
loans  in  foreign  money  centers. 

Each  of  these  transactions  has  the  effect  of  creating  credits 
in  foreign  countries  for  American  bankers.  The  demand  for 
bankers'  drafts  drawn  upon  these  credits  comes  principally 
from  the  following  sources: 


DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE    33 


(a)  The  importation  of  foreign  goods. 

(b)  The  purchase  of  foreign  freight  and  banking  services. 

(c)  Investment  by  Americans  in  securities  sold  by  for- 
eigners. 

(d)  Payment  of  interest  and  dividends  by  American  bor- 
rowers to  foreigners. 

(e)  Expenditures  abroad  by  the  American  Government  and 
tourists. 

(/)  Repayment  by  New  York  of  short-term  loans  con- 
tracted in  foreign  money  centers. 

This  tabulation  does  not  pretend  to  be  exhaustive;  many 
transactions,  more  or  less  unique  in  character,  are  continu- 
ally occurring  to  create  a  demand  for  or  supply  of  bills  of  ex- 
change, but  these  are  insignificant  in  comparison  with  the 
major  forces  at  work.  If  we  were  to  attempt  to  represent 
these  forces  during  a  given  period  in  the  form  of  an  account, 
by  crediting  those  transactions  which  increased  the  Euro- 
pean balances  of  American  banks  and  debiting  those  whose 
effect  was  to  deplete  these  balances,  the  resulting  account 
would  be  somewhat  like  that  given  in  the  accompanying  table: 

Trade  Statement  United  States  with  Europe,  January  1, 1919, 
TO  September  15,  1920  * 

Debits  to  U.S.  banks  (000,000  omitted)  Credits  to  U.S.  Banks 


Merchandise  imports $1,805.00 

United  States  tourists. . . .        75.00 

Immigrants'  remittances  .      450.00 

Loans  by  Government  and 
people  of  the  United 
States  to  Europe 3,519.60 

American  securities  repur- 
chased        200.00 

Securities  of  other  nations 

purchased  from  Europe.      101.00 

Gold  received 183.00 

Total  debit $6,333.00 

Net  credit 3,772.40 

$10,106.00 


Merchandise  exports $8,405.00 

Silver  exports 30.00 

Freight  balance 125.00 

Ships  sold  to  Europe 20.00 

European  securities  matur- 
ing     1,135.00 

Interest  paid  by  Europe 
to  people  and  Govern- 
ment of  United  States  . .      391.00 


$10,106.00 


♦  This  statement  is  adapted  from  a  table  published  by  B.  M.  Anderson,  Jr.,  in  The  Chase 'Eco- 
nomic bulletin.  October  6,  I'J'iO.  Some  of  the  fi({ures  are  eslininles,  but  the  tK)ssibility  of  error 
involved  in  this  fart  does  not  disqualify  the  statement  aa  an  illustration  of  the  forces  at  work  iu 
the  exchange  market. 


81  FOREIGN  EXCHANGE 

Exnmination  of  this  statement  will  show  that  the  European 
crctiits  of  American  banks  during  this  period  were  produced 
chiolly  1>,V  our  immense  exports  of  goods,  the  payment  of 
interest  hy  European  dehlors,  and  the  repayment  hy  these 
debtors  of  various  portions  of  their  debt  to  us,  with  smaller 
additions  to  the  credits  by  reason  of  a  freight  balance,  silver 
exports,  and  the  sale  of  ships.  The  principal  offsets  against 
these  credits  were  caused  by  our  imports,  various  forms  of 
investment  in  foreign  securities,  and  the  remittances  of  im- 
migrants, with  lesser  effects  of  the  same  nature  due  to  our 
receipts  of  gold  and  the  expenditures  of  our  tourists.  The 
fact  need  not  be  emphasized  that  this  statement  relates  to  a 
time  when  conditions  were  very  abnormal;  evidence  of  this 
fact  is  to  be  seen  in  the  tremendous  favorable  balance  of 
trade,  the  abnormal  amount  of  international  trading  in  securi- 
ties, and  the  uncancelled  balance  of  almost  three  and  three 
quarters  billions  of  dollars.  It  must  not  be  assumed  that  this 
uncancelled  balance  was  left  standing  to  the  credit  of  Amer- 
ican banks  in  foreign  cities;  the  major  portion  of  it  was  ab- 
sorbed by  American  citizens  and  credit  institutions  through 
various  forms  of  foreign  investment  which  could  not  be 
traced  and  which,  therefore,  were  omitted  from  the  statement. 

13.  Balancing  international  payments  by  means  of  bills  of 
exchange.  When  we  view  the  foreign  bill  of  exchange  from 
the  standpoint  of  the  individual  whose  commercial  transac- 
tion has  been  facilitated  by  its  use,  we  discover  that  the  prime 
function  of  the  bill  is  to  substitute  for  a  credit  payable  in  a  dis- 
tant place,  in  a  foreign  coinage,  and  (usually)  at  a  later  date, 
funds  payable  in  the  creditor's  locality,  in  the  money  of  his  own 
country,  and  (usually)  available  immediately.  Changing  our 
point  of  view  and  considering  the  aggregate  effect  of  deal- 
ings in  foreign  bills  upon  the  different  markets  of  the  world, 
we  discover  that  these  bills  have  a  national  as  well  as  an  indi- 
vidual significance.  The  various  sources  from  which  are  drawn 
the  total  supply  of  bills  of  exchange  in  the  New  York  market 
have  one  characteristic  in  common:  they  all  represent  the 
sale  by  Americans  to  foreigners  of  goods,  services,  or  property 
rights;  and  the  various  sources  from  which  arises  the  demand 


DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCILVNGE    35 

for  bankers'  bills  in  the  New  York  market  also  have  one 
characteristic  in  common:  they  all  represent  the  purchase 
from  foreigners  of  goods,  services,  or  property  rights.  In  so 
far  as  these  many  international  transactions  are  cleared  up 
by  the  use  of  bills  of  exchange  without  the  transfer  of  money 
from  one  nation  to  another,  the  national  significance  of  the 
exchange  operations  is  this:  to  enable  the  nation  to  pay  with 
her  goods,  services,  and  property  rights  for  her  purchases  of 
these  things  from  the  peoples  of  foreign  nations.  Through  the 
medium  of  bills  of  exchange  international  trade  is  reduced  to 
barter. 

To  illustrate  and  make  clear  this  important  result  of  ex- 
change operations,  we  may  use  our  trade  with  Great  Britain 
as  an  exemplar  of  our  entire  international  commerce.  We 
have  seen  that  whenever  payments  are  due  Americans  from 
persons  in  Great  Britain  on  account  of  goods  or  property 
rights  sold,  or  services  rendered,  the  exchange  bankers  as- 
sume the  right  to  receive  these  payments  by  taking  up  the 
bills  of  exchange  of  the  American  creditors  and  either  ad- 
vancing the  money  due  or  transferring  it  at  the  time  of 
collection.  On  the  other  hand,  whenever  Americans  have 
payments  to  make  to  persons  in  Great  Britain,  the  bankers 
undertake  to  make  these  payments;  they  receive  the  Amer- 
ican's money  and  either  give  him  a  bill  of  exchange  payable 
abroad  or  present  to  him  a  bill  drawn  by  the  English  seller. 
The  exporters  and  other  sellers  in  our  international  trade 
create  for  our  bankers  credits  in  London;  our  importers  and 
other  buyers  avail  themselves  of  these  credits  for  making  pay- 
ments to  English  creditors. 

If,  now,  our  trade  with  Great  Britain  over  a  given  period 
balances  so  nicely  that  the  bills  drawn  by  our  exporters  (and 
other  sellers)  exactly  equal  the  demand  from  our  importers 
(and  other  buyers),  the  accounts  of  the  banks  concerned 
in  the  transactions  will  balance.  Under  such  conditions, 
whether  we  view  the  situation  from  the  American  or  the  Brit- 
ish side,  we  may  say  that  our  foreign  sales  have  paid  for  our 
foreign  purchases.  The  function  of  tlie  bankers  will  li;ive 
been  merely  that  of  middlemen  bringing  exporter  and  im- 


36  FOREIGN  EXCIUNGE 

jx^rler  togctlier  so  that  the  credit  of  the  former  in  Great 
Britain  could  be  used  hy  the  latter  to  pay  his  debt  there.  It 
is  at  least  conceivable  that  the  cancellation  of  international 
payments  might  have  been  accomplished  without  the  aid  of 
bankers.  Let  the  American  exporter  draw  on  his  English 
debtor  and  sell  his  draft  directly  to  an  American  importer  who 
needs  a  sterling  bill;  let  the  latter  transfer  his  bill  to  his 
creditor,  who  may  then  collect  the  amount  from  the  British 
exporter  on  whom  the  bill  is  drawn.  By  this  arrangement 
the  importers  of  each  country  will  pay  over  to  the  exporters 
of  their  own  country  the  money  due  the  latter,  and,  assum- 
ing as  we  do,  an  equality  of  exports  and  imports,  the  ac- 
counts of  the  two  nations  will  balance.  The  interposition  of 
the  bankers  in  the  transaction  is  merely  for  the  convenience 
of  both  parties.  The  fact  that  they  do  not  sell  to  importers 
the  same  bills  which  they  buy  from  exporters,  but  use  these 
bills  to  create  credits  against  which  they  draw  their  own 
drafts,  in  no  wise  alters  the  principle  involved.  Under  the 
given  conditions  of  equal  purchases  and  sales,  the  financing 
of  our  trade  with  Great  Britain,  whether  carried  through 
with  or  without  the  aid  of  middlemen,  will  be  consummated 
by  the  bartering  of  exports  against  imports. 

The  same  principle  of  barter  applies  when  we  bring  into  the 
account  all  other  transactions  for  w^hich  payment  must  be 
made  between  the  two  nations.  Of  these  transactions  some 
will  be  financed  in  such  a  way  as  to  bring  British  banks  into 
the  debt  of  American,  while  the  financing  of  others  will  use 
up  these  credits  as  bankers'  drafts  are  drawn  against  them. 
If  the  accounts  of  the  two  nations  come  to  a  balance  at  the 
end  of  any  given  period  without  the  shipment  of  money,  it 
will  be  because  all  payments  which  Americans  have  owed 
Britons  have  just  sufliced  to  offset  payments  which  Britons 
have  owed  Americans,  whatever  the  nature  of  the  transac- 
tion for  which  these  payments  were  due.  Thus  in  the  past, 
Britain  has  bought  from  us  great  quantities  of  cotton  and 
foodstuffs  each  year  and  has  paid  for  these  things  in  part 
with  her  manufactured  goods,  in  part  with  the  services  of  her 
merchant  marine  and  banking  mechanism,  and,  in  part  by 


DEMAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE    37 

cancelling  interest  and  dividends  which  we  have  owed  her. 
Her  purchases  from  us,  though  effected  by  thousands  of  un- 
related transactions  between  individual  merchants,  have  all 
combined  to  give  x\merican  banks  credit  in  London,  while 
the  divers  forms  of  service  which  she  has  rendered  us,  though 
similarly  unrelated  in  detail,  have  also  combined  to  exhaust 
these  credits.  No  individual  in  either  country  who  took  part 
in  the  transactions  between  the  two  need  have  been  aware  of 
this  outcome  of  his  commercial  operations.  Each  importer 
and  exporter,  each  shipper  and  security-holder,  each  tourist 
and  banker,  may  have  conducted  his  transactions  with 
reference  only  to  his  individual  inclination  or  profit,  yet,  by 
adding  to  the  supply  of  bills  of  exchange  or  to  the  demand, 
all  of  these  individuals  have  cooperated  to  enable  the  two 
nations  to  reduce  their  commercial  relations  to  a  plane  of 
barter. 

The  process  of  cancellation  of  debits  against  credits  can, 
of  course,  never  entirely  clear  up  the  trade  statements  of  the 
two  nations,  for  it  is  inconceivable  that  the  commercial 
transactions  between  them  could  ever  exactly  offset  each 
other.  But  where  a  balance  remains  uncancelled,  the  use  of 
bills  of  exchange  makes  it  possible  to  draw  a  third  country 
and  a  fourth  and  fifth  into  the  account  to  bring  it  more  nearly 
to  equilibrium.  The  United  States  has  for  years  sold  more 
goods  to  Great  Britain  than  she  has  bought  from  that  country, 
and,  consequently,  the  supply  of  sterling  bills  in  American 
markets  has  exceeded  the  demand  of  the  buyers  of  Enghsh 
goods,  services,  and  property  rights.  Our  trade  with  Brazil 
and  other  South  American  countries,  and  with  the  Far  East, 
has  taken  off  a  part  of  this  surplus.  Brazil,  for  example, 
normally  imports  from  Great  Britain  more  than  she  exports 
to  her;  consequently,  her  own  export  trade  with  England 
does  not  suffice  to  satisfy  the  demand  for  sterling  bills  in 
Brazil.  We,  on  the  other  hand,  have  bought  from  Brazil 
more  than  we  have  sold  her  and  have,  therefore,  been  in  her 
debt  on  the  Ijalance  of  trade.  Thus  a  triangular  situation  has 
existed:  we  have  had  unuBcd  credits  in  England;  Brazil  has 
had  need  for  these  credits;  and  we  have  been  in  Brazil's  debt. 


!!  8 1 1;  5 


38  FOREIGN  EXCHANGE 

liy  Iransferrinp  a  portion  of  our  sterling  credit  to  Brazil,  we 
havo  paid  our  debt  there  and  given  her  the  means  of  paying 
her  debt  to  England. 

To  illustrate  by  a  practical  example:  Suppose  a  firm  of 
cofToo  importers  in  New  York  to  be  under  the  necessity  of 
rtMiiittin^'  payment  to  the  exporters  in  Brazil;  this  payment 
can  be  made  in  sterling  bills,  because  the  Brazilian's  banker, 
having  use  for  a  credit  in  London,  will  buy  the  sterling  bills 
from  the  coffee  exporter.  Hence  the  New  York  importer 
may  go  to  his  banker  and  by  paying  the  amount  he  owes  for 
the  coffee  either  get  sterling  bills  which  he  may  send  to  his 
creditor  in  Brazil,  or  an  authorization,  issued  by  the  banker 
in  favor  of  the  Brazilian,  which  will  allow  the  latter  to  draw 
the  sterling  bills  against  the  banker's  credit  in  London.  That 
is  to  say,  the  New  York  importer  pays  a  New  York  banker  for 
his  coffee;  the  Brazilian  exporter  receives  his  money  from  that 
banker  in  Brazil  who  buys  his  sterling  bills,  and  when  the 
bills  arrive  in  London,  they  are  charged  against  the  credit  of 
the  New  York  banker  there.  In  essence  what  has  happened 
is  this:  we  have  instructed  Great  Britain  to  discharge  a  por- 
tion of  her  debt  to  us  by  paying  our  Brazilian  creditors.  If 
we  look  only  at  that  part  of  this  transaction  which  takes 
place  in  New  York,  we  shall  see  that  the  coffee  importer  is  in 
reality  paying  some  American  exporter  for  goods  which  he 
sells  to  Britain;  for  the  banker  in  New  York  is  able  to  com- 
mand a  sterHng  credit  in  London  because  he  has  bought,  or 
is  about  to  buy,  the  sterling  bills  of  exporters.  And  thus  the 
sale  of  our  goods  to  Great  Britain  pays  a  part  of  the  debt  we 
owe  Brazil  for  our  purchases  there. 

We  have  purposely  avoided  mention  of  the  technicalities 
and  the  variations  of  procedure  in  these  triangular  exchange 
operations,  for  it  is  our  present  purpose  to  examine  only  their 
effect  upon  the  markets  of  the  nations  as  a  whole.  During 
the  last  years  of  normal  trade  preceding  the  Great  War,  a 
large  proportion  of  all  our  imports  from  countries  outside  of 
Europe  and  Canada  was  paid  in  sterling  bills.  This  wide- 
spread use  of  our  credits  in  London  as  purchasing  power  in 
distant  markets  has  been  possible  because  of  the  ever-present 


DEIVIAND  AND  SUPPLY  OF  BILLS  OF  EXCHANGE    39 

demand  throughout  the  world  for  bills  drawn  on  England,  a 
demand  to  be  attributed  to  the  dominant  position  in  inter- 
national trade  which  London  has  enjoyed.  In  later  chapters 
we  shall  study  the  causes  of  London's  supremacy  as  well  as 
the  technical  details  of  this  exchange  of  credit;  it  is  our  pres- 
ent concern  merely  to  note  that  this  extension  of  our  use  of 
sterling  bills  has  had  its  result  in  offsetting  our  exports  to 
Great  Britain  against  our  purchases  of  goods,  services,  and 
property  rights,  not  only  from  Great  Britain,  but  from  many 
other  countries  as  well.  So  customary  has  the  employment  of 
bills  of  exchange  become  in  international  trade,  and  so  highly 
perfected  the  mechanism  of  the  exchange  markets,  that  the 
whole  world  has  been  drawn  together  into  a  close  association 
for  the  offsetting  of  debits  and  credits.  Every  resource  for 
cancellation  will  be  exhausted  before  any  purchaser  in  inter- 
national commerce,  whatever  his  home  or  the  home  of  his 
seller,  is  compelled  to  make  payment  by  the  shipment  of 
money.  Yet  none  of  the  parties  to  these  countless  trans- 
actions, with  the  exception  of  the  bankers  who  act  as 
middlemen,  makes  conscious  effort  to  achieve  this  result. 
Each  is  left  free  to  seek  out  his  own  advantage  by  buying  and 
selling  in  the  best  markets  and  upon  the  best  terms,  and  each 
makes  use  of  bills  of  exchange  only  because  by  so  doing  his 
profit  is  increased.  Out  of  this  complex  of  individual  trans- 
actions emerges  for  the  nation  the  one  final  result:  through 
the  use  of  bills  of  exchange,  her  total  credits  from  all  sources 
and  in  all  markets  are  offset  as  far  as  possible  against  the  total 
of  her  debits  from  all  sources  and  in  all  markets. 


CHAPTER  in 

RATES  OF  EXCHANGE 

14.  Determining  factors  of  the  rates  of  exchange.  The 
expression  rate  of  exchange  signifies  the  terms  upon  which 
bills  payable  in  foreign  moneys  will  be  exchanged  for  dollars 
and  cents.  At  the  outset  of  our  inquiry  into  the  nature  and 
significance  of  rates  of  exchange,  it  is  necessary  to  emphasize 
the  fact  that  no  single  rate  can  apply  to  all  the  varieties  of 
bills  which  may  be  drawn  in  a  designated  foreign  money. 
Foreign  bills  of  exchange  are  not  of  uniform  quality,  like  bank 
notes  or  treasury  certificates;  on  the  contrary,  they  are 
credit  instruments  whose  value  is  influenced  by  the  confidence 
of  the  buyer  in  their  ultimate  rederhption  by  the  drawee. 
Varying  in  the  degree  of  risk  attached  to  their  purchase,  as 
they  of  necessity  do,  they  command  prices  which  vary  in 
conformity  with  the  risk  element.  Moreover,  in  many  cases 
the  bill  is  so  drawn  that  an  interval  of  time  must  elapse 
between  the  outlay  caused  by  its  purchase  and  the  income 
caused  by  its  redemption,  and  the  buying  price  must  take 
account  of  the  loss  of  interest  due  to  this  delay.  When  a 
single  rate  of  exchange  is  spoken  of  as  the  rate,  reference  is  had 
to  that  type  of  bill  upon  which  these  factors  of  risk  and 
interest  exert  the  slightest  influence:  namely,  bankers' 
demand  drafts.  The  demand  rate  of  exchange  is  everywhere 
the  governing  rate  of  the  market;  all  other  rates  are  derived 
from  it  in  conformity  with  the  degree  of  risk  and  the  loss  of 
interest  involved  in  the  purchase  of  the  bills  to  which  these 
rates  apply.  Accordingly,  in  this  preliminary  discussion  we 
shall  use  the  expression  rate  of  exchange  to  mean  the  terms 
v!  upon  which  a  banker  will  sell  for  dollars  and  cents  his  demand 
draft  drawn  upon  a  foreign  country. 

Under  competition,  a  banker's  selling  rate  for  his  foreign 
demand  bills  —  called,  in  the  parlance  of  the  market,  the 


RATES  OF  EXCHANGE  41 

drawing  rate  for  checks  on  the  foreign  city  concerned  —  will 
represent  his  estimate  of  the  desirability  of  the  bill  to  him- 
self. Now,  there  are  two  attributes  of  these  foreign  demand 
bills  (it  must  be  recalled  that  we  have  abstracted  the  factors 
of  risk  and  interest)  which  affect  their  desirability  to  the 
dealers  in  the  market.  In  the  first  place,  the  bill  transfers 
ownership  in  a  foreign  credit  which  gives  the  owner  the  right 
to  receive  a  foreign  money;  in  the  second  place,  this  credit 
is  situated  in  a  foreign  city  and  payment  will  be  made  in  that 
city.  To  retain  possession  of  the  bill,  therefore,  means  for 
the  banker  continued  ownership  in  this  foreign  credit  so 
situated.  Over  against  the  desirability  of  this  ownership, 
the  banker  will  set  the  compensation  he  will  receive  for 
drawing  the  demand  bill;  this  compensation  will  consist  in 
a  payment  made  to  him  in  his  own  money  and  at  his  own 
place  of  business.  The  pricing  of  the  bill  will,  therefore,  be 
the  outcome  of  the  balancing  of  these  two  sets  of  factors  in 
the  mind  of  the  banker: 

(a)  The  intrinsic  worth  of  the  foreign  coin  versus  the  in- 
trinsic worth  of  the  domestic. 

\b)  The  usefulness  of  funds  in  a  foreign  city  versus  the  use- 
fulness of  funds  at  home. 

To  illustrate,  assume  that  a  banker  in  New  York  is  asked 
to  sell  for  dollars  a  demand  bill  calling  for  the  payment  of  two 
thousand  pounds  sterling  in  London;  how  can  he  intel- 
ligently set  a  price  on  the  demand  bill?  Obviously,  he  must 
take  account  of  the  two  factors  we  have  mentioned;  that  is 
to  say,  he  must  consider  how  the  intrinsic  value  of  the  gold 
sovereign  compares  with  that  of  the  gold  dollar,  and,  also, 
how  much  two  thousand  gold  sovereigns  are  worth  to  him 
in  their  present  location  in  London,  as  compared  with  the 
worth  to  him  of  their  equivalent  in  New  York.  Let  us  as- 
sume for  the  moment  that  the  location  of  his  funds  is  a  matter 
of  indifference  to  the  banker.  Under  this  assumi)tion,  the 
sale  of  a  demand  bill  will  represent  a  simple  conversion  of  one 
kind  of  money  into  another;  the  banker's  problem  would  not 
be  different  if  gold  sovereigns  and  gold  dollars  were  lying  in 
two  heaps  upon  his  counter  and  he  were  asked  to  exchange 


42  FOREIGN  EXCHANGE 

two  tlinusand  of  the  one  for  their  equivalent  in  the  other. 
The  hankor's  rate  of  cxchanfi;e  would  merely  express  e(iuiva- 
lonce  between  the  intrinsie  values  of  the  two  kinds  of  money; 
this  rate  would  be  called  par  of  exchange  in  the  market. 

But  we  have  only  to  make  this  assumption  to  realize  that 
it  is  very  far-fetched.  It  can  never  be  a  matter  of  indifference 
to  the  banker  whether  his  funds  are  at  home  or  in  a  foreign 
city;  it  is,  on  the  contrary,  sometimes  more,  sometimes  less, 
desirable  for  bankers  in  New  York  to  have  funds  under  their 
control  in  London,  and,  as  a  consequence,  the  bills  of  ex- 
change which  affect  the  amount  of  these  funds  are  more 
willingly  sold  at  certain  times  than  at  others.  Reflecting 
this  difference  in  his  willingness  to  sell,  the  banker  will  offer 
his  bills  at  rates  of  exchange  which  deviate  from  par,  either 
rising  above  or  falling  below  the  point  which  expresses  equal- 
ity between  the  two  systems  of  coinage.  Both  attributes  of 
the  foreign  bill  of  exchange  —  the  fact  that  they  effect  the 
exchange  of  one  kind  of  money  for  another,  and  the  fact  that 
they  decrease  the  seller's  funds  in  a  foreign  center  —  must 
be  taken  into  account  when  attempting  to  explain  the  rates 
which  rule  the  market,  for  each  has  its  distinctive  part  to 
play  in  determining  these  rates.  In  brief,  the  influence  of 
the  two  factors  may  be  expressed  as  follows:  the  money 
factor  of  a  given  bill  determines  the  par  rate  for  that  bill;  the 
location  factor  determines  the  daily  fluctuations  of  the  rate 
above  and  below  par. 

15.  Money  factors  and  the  mint  pars  of  exchange.  Each 
coinage  system  of  the  world  has  its  own  peculiar  mint  par  of 
exchange  w^th  the  coinage  system  of  the  United  States,  the 
quotation  in  each  case  expressing  equivalence  between  the 
intrinsic  values  of  the  standard  foreign  coin  and  the  dollar. 
From  the  point  of  view  of  their  systems  of  coinage,  the  trading 
nations  of  the  world  may  be  divided  into  three  groups:  first, 
and  most  important,  is  that  group  of  the  most  powerful  and 
most  advanced  of  the  nations,  W'hose  monetary  system  is 
based  on  the  gold  standard;  secondly,  a  considerable  group 
of  less  progressive  nations  whose  standard  coin  is  made  of 
silver;  thirdly,  a  group  of  nations  whose  monetary  systems. 


RATES  OF  EXCHANGE  43 

temporarily  or  permanently,  are  composed  of  an  irredeemable 
paper  money.  Among  these  groups  of  nations  there  are  three 
major  combinations  to  be  considered:  (A)  par  of  exchange 
between  two  gold  standard  countries;  (B)  par  of  exchange 
between  a  gold  standard  and  a  silver  standard  country;  (C) 
par  of  exchange  between  a  gold  standard  country  and  a 
country  using  an  irredeemable  paper  money.  The  other 
three  possible  combinations  —  pars  between  two  silver 
standard  countries,  two  paper  standard  countries,  and  a 
silver  and  a  paper  standard  country  —  need  not  be  con- 
sidered at  length,  since  the  principles  which  determine  these 
pars  may  be  derived  from  those  governing  the  three  major 
combinations. 

The  standard  money  of  any  system  is  that  kind  of  money  in 
which  all  other  kinds  are  made  redeemable  by  the  law  of  the 
nation.  The  other  forms  of  money  which  comprise  the  sys- 
tem may  be  grouped  together  under  the  term  fiduciary  vioney, 
since  they  depend  for  their  currency  and  their  value  upon  the 
faith  of  the  people  in  their  redeemability  in  the  standard 
money  at  the  option  of  the  holder.  If  the  standard  money  is 
composed  of  metal,  the  size,  weight,  and  fine  metal  content  of 
the  coin  will  be  fixed  with  great  precision  by  the  coinage  laws 
of  the  nation;  if  paper  is  the  standard,  the  description  of  the 
standard  note  will  be  similarly  fixed  by  law.  la-addition  to 
these  two  kinds  of  money,  the  circulating  medium  of  most 
countries  contains  a  number  of  other  things  which  are  not 
money  at  all,  but  which,  nevertheless,  do  the  work  of  money 
with  more  or  less  efficiency;  chief  among  these  are  bank 
deposits  subject  to  check.  The  value  of  these  non-monetary 
kinds  of  currency  is,  likewise,  dependent  upon  their  converti- 
bility into  the  standard  money  of  the  system.  So  long  as  the 
nation  adheres  faithfully  to  its  standard  —  that  is,  so  long 
as  it  continues  freely  to  redeem  all  kinds  of  money  in  standard 
money  on  demand  —  the  various  coins  and  notes  which  com- 
pose its  system  will  have  a  uniform  value  and  will  be  ac- 
cepted by  the  people  with  no  other  discrimination  than  that 
based  on  the  convenience  of  handling  them.  To  maintain  a 
gold  standard,  then,  a  nation  need  not  use  gold  money  as  its 


44  FOREIGN  EXCIL\NGE 

sole,  or  even  as  its  chief,  mediuin  of  exchange;  in  fact,  it  may 
efTect  its  exchanges  through  a  medium  which  is  not  money 
at  all,  but  currency.  It  is  sufficient  to  characterize  a  nation's 
monetary  system  as  a  gold  or  silver  standard  system  when 
the  values  of  all  other  kinds  of  money  are  kept  at  par  with 
that  of  the  standard  money  by  reason  of  the  instant  and 
continuous  convertibility  of  the  former  into  the  latter. 

(.1)  Mint  par  oj exchange  between  tivo  gold  standard  countries. 
Gold  and  silver  are  commodities  in  international  commerce 
essentially  similar  to  all  other  commodities.  In  selecting 
gold  as  the  standard  of  its  monetary  system,  a  nation  merely 
prescribes  that  a  certain  amount  of  this  commodity,  of  a  cer- 
tain specified  degree  of  fineness,  shall  be  contained  in  the 
standard  coin.  Unlimited  and  unrestricted  minting  of  gold 
into  coins  of  the  prescribed  weight  and  quality,  at  the  option 
of  the  owners  of  gold,  brings  it  about  that  the  standard  coin 
of  the  system  has  the  same  value  in  the  form  of  bullion  as  it 
has  in  the  form  of  money;  that  is  to  say,  this  standard  coin 
when  full  weight  (not  abraded  by  much  use)  may  be  melted 
down  into  raw  gold  without  loss  of  value.  As  a  consequence 
of  this  fact,  a  standard  coin  of  gold  is  an  exportable  article 
which  may  be  sold  outside  the  boundaries  of  the  nation  as  a 
bit  of  precious  metal  whose  quantitj'^  and  quality  are  cer- 
tified. The  standard  coins  of  two  gold  standard  countries 
may  best  be  considered  simply  as  two  different  quantities  of 
the  same  metal;  they  will  exchange  for  each  other  on  the  same 
principles  as  those  which  govern  the  exchange  of  bushels  of 
wheat  for  pecks  of  wheat,  or  of  ounces  of  platinum  for  pounds 
of  platinum.  Par  of  exchange  between  two  gold  standard 
countries  is,  therefore,  determined  by  the  laws  of  arithmetic; 
the  rule  for  this  par  of  exchange  may  be  stated  as  follows: 
between  two  gold  standard  countries,  par  of  exchange  is 
determined  by  computing  Iwio  many  units  of  one  standard 
coin  are  required  to  supply  the  fine  gold  content  of  one  unit  of 
the  second  standard  coin.  The  same  formula  may  be  used  to 
determine  the  par  of  exchange  between  two  silver  standard 
countries. 

The  principal  gold  standard  countries  of  the  world  are  the 


RATES  OF  EXCHANGE 


45 


united  States,*  England  and  her  Australasian  colonies, 
France  *  and  certain  countries  which  have  based  their 
monetary  system  on  the  French  unit  of  coinage,  Germany 
and  Japan.  The  standard  coins  of  these  nations  conform  to 
the  following  description: 


Country 

Name  of 
standard  coin 

Gross  weight 
in  grains 

Degree  of 
fineness 

Weight  of  pure 
metal  in  grains 

United  States .  . 
Great  Britain  . . 

France 

Germany 

dollar 

pound  sterling 

franc 

mark 

25.8 
123.274 
4.978 
6.1458 

9/10 

11/12 

9/10 

9/10 

23.22 
113.0016 
4.4803 
5.5313 

The  English  monetary  system  is  divided  into  the  following 
parts : 


1  pound  equals  20  shillings* 
1  shilling  equals  12  pence. 
1  penny  equals  four  farthings. 


.2  4  1 


The  symbols  which  represent  these  different  kinds  of  money 
are  somewhat  peculiar.  The  sum,  one  pound,  one  shilling, 
and  one  penny  is  written,  £l  Is.  Id.  or,  £l  l/l.  The  Australa- 
sian colonies  of  Great  Britain  use  the  same  monetary  system 
and  the  same  symbols  when  expressing  the  system  in  figures. 
The  French  monetary  system  is  divided  as  follows: 

1  pound  (napoleon)  equals  20  francs. 
1  franc  equals  100  centimes. 

There  is  also  a  silver  piece  of  five  francs  which  is  not  redeem- 
able by  law  in  standard  gold,  but  which  is  maintained  at 

'  Both  the  United  States  and  France  have  a  qualified  gold  standard.  In 
each  of  these  countries  there  are  silver  coins  —  the  dollar  and  the  five-franc 
piece,  respectively  —  with  full  legal-tender  value  whose  redemption  in  gold  is 
not  expressly  provided  by  law.  In  the  United  States,  however,  the  silver 
dollar  is  kept  at  par  with  the  gold  dollar  by  the  operation  of  the  law  of  1900 
whifh  hinds  the  Secretary  of  the  Treasury  to  maintain  this  parity;  in  France 
a  sitnilar  parity  is  mainUiined  by  the  practice  of  redeeming  the  silver  in  gold. 
The  coinage  of  both  of  these  silver  units  is  limited  by  law. 


46  FOREIGN  EXCHANGE 

parity  with  the  gold  coins  by  reason  of  the  fact  that  the 
mints  are  closetl  to  the  coinage  of  silver  and  the  Bank  of 
France  in  normal  times  freely  redeems  the  five-franc  piece  in 
gohl.  The  systems  of  the  following  countries  are  based 
nominally  upon  the  French  unit  of  coinage,  though  in  some 
of  them  the  gold  standard  is  of  theoretical  importance  only, 
since  the  actual  medium  of  exchange  is  an  inconvertible  paper 
money. 

Country  N^me  of  coin  Relation  to  franc 

Switzerland franc  same  weight 

Belgium franc  same  weight 

Italy lira  same  weight 

Spain peseta  same  weight 

Greece drachma  same  weight 

Bulgaria leva  same  weight 

Servia dinar  same  weight 

Rumania leu  same  weight 

Venezuela bolivar  same  weight 

Argentina peso  5  times  the  weight 

Paraguay peso  5  times  the  weight 

Ecuador sucre  23^  times  the  weight 

The  German  coinage  is  divided  as  follows: 

1  pound  equals  20  marks. 
1  mark  equals  100  pfennigs. 

In  all  of  these  countries  there  is  subsidiary  and  token  money 
of  silver  and  other  metals,  as  well  as  paper  notes  representing 
different  units  of  the  standard  money.  In  all  of  them,  how- 
ever, with  the  exception  of  the  5  franc  silver  piece  of  France, 
the  different  notes  and  coins  are  legally  redeemable  in  gold  and 
are  maintained  at  a  parity  with  gold  by  virtue  of  this  redeem- 
ability.  It  need  hardly  be  urged  that  these  statements  take 
no  account  of  the  collapse  of  the  monetary  systems  of  the 
world  which  has  resulted  from  the  war. 

Given  the  v/eights  of  the  standard  gold  coins  in  the  different 
countries,  their  mint  pars  with  the  dollar  may  be  derived  by 
a  simple  process  of  division.  The  gold  dollar  contains  23.22 
grains  of  fine  gold;  the  pound  sterling,  113.0016  grains  of  fine 


RATES  OF  EXCHANGE  47 

gold.  Hence,  par  of  exchange  between  the  United  States 
and  Great  Britain  is : 

one  pound  sterling  equals  $4.8665. 
(113.0016  -^  23.22  =  4.8665.) 

The  franc  contains  4.48035  grains  of  fine  gold;  the  dollar, 
23.22  grains;  hence,  par  of  exchange  with  France  is: 

one  dollar  equals  5.1826  francs. 
(23.22  -^  4.48035  =  5.1826.) 

The  mark  contains  5.53134  grains  of  fine  gold;  the  dollar, 
23.22  grains;  hence,  par  of  exchange  with  Germany  is 

one  dollar  equals  4.1979  marks. 
(23.22  -^  5.53134  =  4.1979.) 

These  pars  will  remain  unchanged  so  long  as  the  nations  con- 
cerned do  not  alter  their  mint  laws  so  as  to  change  the  fine 
metal  content  of  their  standard  coins. 

The  mint  pars  between  the  United  States  and  the  principal 
gold  using  countries  are  given  in  the  following  table  in  the 
form  in  which  they  are  usually  expressed. 

Country  Pars  of  exchange  mth  the  United  States 

England $4.8665  equals  1  pound  sterling 

Germany $23.83  equals  100  marks 

Spain $19.30  equals  100  p)esetas 

Holland $40.20  equals  100  guilder 

Scandinavia $26.80  equals  100  kronen 

Japan $49.85  equals  100  yen 

Argentina $42.44  equals  100  pesos 

Brazil $32.44  equals  100  milreis 

France 5.1826  francs  equals  $1;  or,  19.3^  equals  1  franc 

Italy 5.1826  lire  equals  $1;  or,  19.3^  equals  1  lira 

Switzerland 5.1826  francs  equals  $1;  or,  19.3^  equals  1  franc 

Belgium 5.1826  francs  equals  $1 ;  or,  19.3^  equals  1  franc 

Without  variation  in  the  method  of  determining  the  mint 
par  of  exchange  between  gold  standard  countries,  the  form 
in  which  the  quotation  appears  may  vary.  Some  financial 
journals  in  the  United  States,  for  example,  customarily  quote 


48  FOREIGN  EXCHANGE 

par  of  exchange  with  Germany  and  Spain  in  so  many  cents 
per  mark  or  peseta;  and  others,  in  so  many  marks  or  pesetas 
per  dollar;  both  of  these  forms  differ  from  the  par  as  expressed 
above,  where  these  currencies  are  quoted  in  units  of  one 
hundred.  It  is  necessary  for  the  student,  in  reading  these 
current  quotations,  to  inform  himself  as  to  the  method  of 
quoting  par  employed  by  each  particular  journal,  otherwise 
he  will  be  confused  by  the  lack  of  uniformity  among  the  quo- 
tations. In  the  New  York  market,  two  different  methods 
are  employed  in  quoting  par  of  exchange  between  the  dollar 
and  other  gold  coins.  Sometimes  —  as  in  the  case  of  England, 
Germany,  Spain,  Holland  —  the  foreign  coin,  or  a  multiple 
of  the  foreign  coin,  is  taken  as  the  unit  and  this  unit  is  quoted 
in  dollars  and  cents;  in  other  cases,  as  in  French,  Italian, 
S^ass,  and  Belgian  exchange,  the  dollar  is  taken  as  the  unit 
and  is  quoted  in  the  foreign  coin.  From  this  difference  in 
method,  confusion  sometimes  arises  in  interpreting  a  quo- 
tation which  expresses  a  discount  or  a  premium.  In  sterling 
exchange,  for  example,  4.8665  is  par,  4.85  is  below  par,  and 
4.87,  above  par,  the  higher  figure  indicating  a  premium  and 
the  lower,  a  discount.  This  is  true  because,  since  pounds  are 
quoted  in  dollars,  a  rising  figure  shows  that  they  are  becom- 
ing dearer  and  a  falling  figure  that  they  are  becoming 
cheaper.  But  in  franc  exchange  5.1826  is  par,  5.17  is  above 
par,  and  5.19  below  par.  Here  the  higher  figure  expresses 
a  discount  and  the  smaller  a  premium,  for  it  is  the  practice  of 
the  market  to  sell  francs  by  the  dollar's  worth,  and  a  rising 
quotation  shows  that  francs  are  becoming  cheaper  in  terms  of 
dollars,  while  the  reverse  is  shown  by  a  falling  quotation.  A 
little  care  taken  at  the  outset  to  acquaint  one's  self  with  the 
practice  of  the  exchange  market  with  regard  to  the  form  of 
quotation  employed  for  the  different  currencies  will  guard 
against  any  misconception  of  this  practice. 

(B)  Between  a  gold  and  a  silver  standard  country,  the  par  of 
exchange  cannot  be  derived  from  the  relative  weights  of  the 
two  standard  coins.  One  grain  of  gold  will  always  exchange 
for  another  grain  of  the  same  degree  of  fineness,  but  no  such 
equivalence  exists  between  two  different  metals,  such  as  gold 


RATES  OF  EXCHANGE  40 

and  silver;  hence,  there  can  be  no  fixed  parity  between  the 
weight  of  gold  in  one  coin  and  the  weight  of  silver  in  another. 
In  the  bullion  market  the  price  of  silver  in  terms  of  gold 
fluctuates  continually  under  the  varying  forces  of  demand  and 
supply;  the  gold  prices  of  silver  coins  change  in  harmony  with 
these  fluctuations,  and  constant  revision  is  necessary  to  cor- 
rect the  par  of  exchange  between  the  United  States  and  the 
silver  standard  countries.  To  illustrate:  the  tael  of  Shanghai 
contains  516.4058  grains  of  fine  silver;  assuming  that  silver 
sells  for  one  dollar  per  fine  ounce  (480  grains),  the  silver  con- 
tent of  the  tael  is  worth  $1,074.  But  when  the  price  of  silver 
rises  to  $1.25  per  fine  ounce,  a  new  par  of  exchange  between 
the  tael  and  the  dollar  results:  namely,  1.342;  while  a  fall  in 
the  price  of  silver  to  $.75  will  reduce  the  par  of  exchange  with 
Shanghai  to  $.806.  These  changes  in  the  silver  pars  contrast 
with  the  relative  fixity  of  the  pars  of  exchange  between  the 
dollar  and  the  standard  coin  of  gold  standard  countries. 
When  two  coins  contain  the  same  metal,  par  of  exchange 
between  them  can  be  altered  only  by  revising  the  coinage 
laws  of  one  country,  or  of  both,  so  as  to  change  the  weight  of 
the  metal  content  of  the  coins;  when  the  two  coins  are  of 
different  metals,  however,  par  of  exchange  varies  with  each 
fluctuation  of  the  market  values  of  the  metals,  as  well  as 
with  each  alteration  in  the  weights  of  the  coins. 

Because  of  the  disturbance  caused  by  this  shifting  of  the 
exchange  values  of  gold  and  silver  coins,  and  of  the  realiza- 
tion that  of  the  two  metals  gold  is  relatively  the  more  stable 
in  value,  most  nations  have  discarded  the  silver  standard  of 
coinage.  Others,  retaining  an  apparent  silver  standard,  have 
adopted  measures  to  bestow  upon  their  coins  a  fixed  ratio  of 
exchange  with  the  gold  coins  of  other  nations.  The  device 
most  frequently  and  effectually  employed  to  produce  this 
fixed  par  between  gold  and  silver  coins  is  the  gold  exchange 
standard;  we  must  postpone  a  discussion  of  this  standard  to  a 
later  point  in  this  chapter,  since  an  explanation  of  it  can 
hardly  be  made  until  some  attention  has  been  paid  to  the 
specie  points  in  the  rates  of  exchange. ' 
*  See  section  19. 


50  FOREIGN  EXCHANGE 

Cliina  remains  the  only  country  of  importance  in  inter- 
national commerce  whose  standard  money  is  composed  of 
silver.  But  it  is  impossible  to  attempt  description  of  the 
complex  monetary  system  of  China;  indeed,  the  term  system 
is  a  misnomer  when  applied  to  Chinese  currency,  for  there 
are,  in  reality,  many  different  systems  in  operation  in  the 
different  trading  centers  of  the  country.  Of  these  systems 
the  coins  most  frequently  quoted  in  the  foreign  exchanges 
are  the  tael  of  Shanghai  and  the  Mexican  dollar  of  Hongkong. 
The  former  is  not,  strictly  speaking,  a  coin,  but  a  unit  of 
weight;  money  payments  when  measured  in  taels  are  usually 
made  in  the  form  of  fine  silver  bullion  made  up  into  ingots 
(called  shoes)  each  weighing  fifty  taels.  The  weight  of  fine 
silver  in  the  tael  is  516.40584  grains;  a  full-wei^t  Mexican 
dollar  contains  377.18098  grains  of  fine  silver. 

In  recent  years,  so  rapid  have  been  the  changes  in  the  gold 
price  of  silver  that  pars  of  exchange  between  the  United 
States  and  silver  standard  countries  have  been  subject  to 
almost  daily  fluctuation,  and,  as  a  consequence  of  this  con- 
dition, it  has  become  the  practice  of  the  exchange  market 
either  to  quote  the  silver  exchanges  as  if  no  par  existed  or  to 
assume  a  nominal  par  which  corresponds  but  roughly  with 
the  true  par  of  exchange  at  the  time.  Thus,  on  June  16, 1920, 
New  York  quoted  the  Far  Eastern  exchanges  as  follows: 

Hongkong  76.50f5  per  Mex.  $1. 
Shanghai  101.00?!  per  tael. 

Standing  by  itself,  this  quotation  does  not  inform  the  reader 
whether  exchange  drawn  on  these  centers  on  this  day  stood  at 
par,  at  a  premium,  or  at  a  discount;  this  can  be  discovered 
only  by  computing  the  true  par  for  the  day  from  the  price  of 
silver  in  the  market  and  the  weight  of  fine  metal  in  the  tael 
and  the  Mexican  dollar,  and  then  comparing  this  par  with 
the  ciuotation  given.  The  influence  of  the  varying  price  of 
silver  upon  the  daily  quotations  and  the  par  of  exchange 
between  New  York  and  Shanghai  is  disclosed  by  the  table 
below. 


RATES  OF  EXCHANGE 


51 


Date 

Price  of  silver 

per  fine  ounce  in 

New  York 

Market  quotation 

Shanghai  Exchange 

in  New  York 

Par  of  exrhanae 
determined  by 
■price  of  silver 

June,  1915 

$  .510 

.681 

.875 

1.071 

1.181 

.90 

56.50 

72.00 

90.36 

113.50 

127.00 

101.00 

54  774 

June,  1916 

73  139 

June,  1917 

93  975 

June,  1918 

115  02 

June,  1919 

126  909 

June,  1920 

96  66 

Attention  is  called  especially  to  a  comparison  of  the  fourth 
column  of  this  table  with  the  second  column;  this  comparison 
will  disclose  how  the  par  of  exchange  between  gold  and  silver 
standard  countries  varies  in  conformity  with  variations  in  the 
price  of  silver.  As  silver  rose  in  price  during  the  years  1915- 
19,  par  of  exchange  with  Shanghai  also  rose;  with  the  fall  in 
the  price  of  silver  which  occurred  between  June,  1919,  and 
June,  1920,  par  of  exchange  also  fell.  During  this  time,  the 
actual  quotation  on  Shanghai  bills  appearing  in  the  New  York 
market  (see  column  three)  was  insufficient  of  itself  to  give  the 
reader  information  as  to  the  true  state  of  the  Far  Eastern 
exchanges. 

(C)  Par  of  exchange  between  a  gold  standard  country  and  a  coun- 
try using  an  irredeemable  paper.  Some  nations  of  the  world  with 
monetary  systems  theoretically  based  upon  a  gold  standard 
employ  solely  a  currency  composed  of  paper  which  is  redeem- 
able in  no  standard  metal.  These  notes,  whose  only  power 
in  exchange  is  bestowed  upon  them  by  the  receiver's  faith  in 
their  ultimate  redemption,  have  a  value  governed  by  their 
quantity;  it  is  possible  by  carefully  restricting  their  issue 
to  give  them  a  reasonably  stable  exchange  value  within  the 
boundaries  of  the  nation.  But  this  achievement  is  rarely 
met  in  history.  The  ease  with  which  the  notes  are  printed 
and  the  inertia  of  Government  which  tempts  to  their  use  as  a 
substitute  for  taxes  or  for  economy  in  governmental  expendi- 
tures, almost  invariably  lead  to  an  excessive  issue.  Under 
the  operation  of  Gresham's  law,  which  states  that  a  cheaper 


5i  FOREIGN  EXCHANGE 

money  invariably  tends  to  drive  a  dearer  out  of  circulation, 
the  paper  cxi)els  gold  from  the  circulating  medium  of  the 
country  wliifh  issues  it.  If  tlie  paper  money  is  issued  in 
sufficient  amounts,  no  gofd  will  be  left  in  circulation;  and  if 
the  issue  is  continued  l)cyond  this  i)oint,  it  will  cease  to  ex- 
change on  equal  terms  with  the  gold  coins  whose  name  it 
bears  —  that  is,  a  premium  on  gold  will  appear.  When  this 
stage  is  reached,  it  is  customary  to  speak  of  the  fiat  paper^ 
as  depreciated  in  value.  In  every  nation  whose  money  system, 
at  this  time  (1921),  is  composed  of  irredeemable  paper,  this 
condition  of  depreciation  has  run  to  lengths  more  or  less 
extreme. 

Irredeemable  paper  money  has  no  currency  outside  the 
boundaries  of  the  nation  which  issues  it;  no  par  of  exchange 
can  be  established  with  the  gold  coins  of  other  nations  until 
the  paper  has  been  turned  into  gold  upon  terms  governed  by 
its  own  depreciation.  In  quoting  bills  of  exchange  drawn  in 
these  paper  units,  it  is  the  custom  of  the  exchange  markets  of 
gold  standard  countries  to  proceed  upon  the  assumption  that 
a  nominal  gold  standard  exists  in  the  paper-using  country, 
and  to  quote  the  paper  bills  at  rates  which  appear  as  a  dis- 
count from  a  nominal  gold  par.  But,  strictly  speaking,  the 
depreciated  paper  is  an  essentially  different  unit  from  the 
gold  coin  whose  name  it  bears,  and  the  old  par  of  exchange, 
which  expressed  equivalence  between  that  gold  coin  and 
another  gold  coin,  cannot  be  held  applicable  to  it.  A  new  par 
of  exchange  must  be  derived  for  each  successive  stage  in  the 
depreciation  of  the  paper  money.  In  determining  this  new 
par,  account  must  be  taken  of  two  possible  conditions  ob- 
taining in  the  paper  standard  country :  (a)  the  paper  country 
may  be  able  to  supply  gold  for  export  at  a  premium  in  terms 
of  the  depreciated  paper;  (6)  the  paper  country  may  be  either 
imwilling  or  unable  to  exchange  gold  for  its  paper  notes  in 
appreciable  amounts  upon  any  terms.  The  method  of  de- 
termining the  par  of  exchange  between  goid"coms'and  the 
fiat  paper  is  governed  by  these  two  conditions. 

When  a  country  whose  money  consists  of  a  depreciated 
paper  is  still  exporting  gold  when  required  to  do  so,  the  new 


RATES  OF  EXCHANGE  BS 

par  of  exchange  between  her  paper  money  and  the  gold  coins 
of  other  nations  may  be  computed  with  sufficient  accuracy 
for  all  practical  purposes  from  the  premium  on  gold  which 
exists  in  her  market.  Moving  freely  in  international  trade, 
gold  serves  as  a  common  denominator  for  the  values  of  dif- 
ferent moneys;  and  the  terms  upon  which  gold  bullion  will  ex- 
change for  the  irredeemable  paper  will  serve  as  an  index  to  the 
ratio  of  exchange  between  this  paper  money  and  the  gold  coins 
of  other  countries.  For  example,  if  sterling  bills  are  bought 
in  the  United  States  at  a  time  when  these  bills  will  be  re- 
deemed in  paper,  but  when  gold  may  be  obtained  for  export  in 
England,  the  purchaser  will  pay  for  these  bills  with  dollars 
each  of  which  may  be  viewed  as  23.22  grains  of  fine  gold;  the 
paper  pounds  received  in  payment  of  his  sterling  bills  in  Eng- 
land may  be  turned  back  into  gold  upon  terms  governed  by 
the  premium  on  gold  in  England.  To  buy  these  bills  at  par,  the 
purchaser  must  receive  enough  paper  pounds  when  they  are 
redeemed  to  command  in  the  bullion  market  of  London  the 
same  amount  of  fine  gold  as  he  expends  in  purchasing  them. 
The  premium  on  gold  will  disclose  the  discrepancy  between  the 
paper  pound  and  the  gold  pound,  and  will,  therefore,  indicate 
to  what  extent  the  old  par  of  exchange  must  be  corrected  to  ex- 
press equivalence  between  the  gold  dollar  and  the  irredeemable 
paper.  If  the  premium  on  gold  in  England  should  be  100  per 
cent  (that  is,  if  the  paper  pounds  were  worth  50  per  cent  of 
their  nominal  gold  equivalent),  the  new  par  of  exchange  on 
sterling  bills  would  be  50  per  cent  below  the  old  par:  $4.8665 
exchange  at  par  with  one  pound  sterling  because,  as  we  have 
seen,  each  of  these  amounts  of  money  contains  113.0016 
grains  of  fine  gold;  when  two  paper  pounds  are  required  to 
buy  this  amount  of  fine  gold,  each  will  obviously  be  worth  in 
gold  dollars  one  half  as  much  as  the  pound  sterling.  As  the 
premium  on  gold  rises  or  falls  in  England,  par  of  exchange 
between  the  irredeemable  paper  and  the  dollar  must  be  cor- 
rected accordingly. 

A  striking  illustration  of  the  effect  of  an  irredeemable  paper 
money  on  the  par  of  exchange  is  to  be  found  in  the  case  of 
those  countries  which,  after  a  prolonged  experience  with  an 


54  FOREIGN  EXCHANGE 

irredeemable  iiaiier,  have  adopted  a  fixed  rate  of  conver- 
^sion  between  the  gold  and  the  paper  units  of  their  coin- 
age systems.  In  Argentina,  for  examj)le,  the  unit  of  coinage 
—  the  peso  —  has  in  its  gold  form  a  par  value  in  United 
States  coin  of  S.OG.^.  But  for  a  long  period  of  time  the  cir- 
culating medium  of  Argentina  was  composed  of  fiat  paper 
money,  irredeemable  and  greatly  depreciated,  which  was 
finally  made  convertible  into  gold  at  the  rate  of^  $.424  per 
peso.  Following  this  action  of  the  Argentine  Government, 
there  were  two  pars  of  exchange  between  the  United  States 
and  Argentina: 

$96.50  equals  100  pesos  (gold). 
$42.40  equals  100  pesos  (paper). 

Whenever  the  conversion  law  of  Argentina  is  changed,  or 
unenforced,  new  pars  of  exchange  between  the  dollar  and  the 
paper  peso  must  be  derived  to  coincide  with  the  depreciation 
of  this  paper  unit  in  terms  of  the  gold  unit  whose  name  it 
bears. 

Thus  far,  we  have  been  considering  only  that  condition 
under  which  gold  is  permitted  to  flow  between  nations,  being 
neither  prohibited  by  governmental  policy  nor  prevented  by 
economic  necessity  from  leaving  the  paper  money  country. 
But  the  expulsion  of  gold  by  the  paper  money,  coupled  with 
the  unfavorable  balance  of  trade  induced  by  the  rising  prices 
of  the  paper  money  comitry,  may  cause  so  great  an  outflow 
of  gold  in  the  channels  of  international  commerce  as  to  ex- 
haust the  gold  stock  of  the  country  and  leave  no  more  avail- 
able for  export.  Wlien  gold  does  not  function  as  an  ofl'set 
to  the  balance  of  payment,  it  loses  its  significance  as  a  com- 
mon denominator  for  the  relative  values  of  the  standard 
coins  of  different  countries.  To  the  buyer  of  franc  or  sterling 
bills  in  the  New  York  market,  the  premium  on  gold  in  France 
or  England  is  of  no  significance  if  it  is  actually  impossible 
for  him  to  turn  his  bills  of  exchange  into  gold  upon  any 
terms.  When  these  nations  are  on  a  paper  basis  and  gold 
j  cannot  be  obtained  for  export,  bills  payable  in  their  markets 
i  will  be  redeemed  in  paper  money,  and  the  paper  money  must 


RATES  OF  EXCHANGE  55 

be  spent  within  the  country,  since  it  has  no  currency  else- 
where. The  buyer  in  New  York  will  pay  for  his  bills  in  gold 
money  whose  value  is  determined  by  its  purchasing  power 
over  American  goods;  he  will  receive,  when  his  bills  are  re- 
deemed, paper  money  whose  value  is  determined  by  its  pur- 
chasing power  over  the  goods  of  the  country  which  has  issued 
it.  In  this  situation  there  is  only  one  accurate  method  of  de- 
termining the  par  of  exchange  between  the  two  countries, 
namely,  by  a  comparison  of  their  relative  price  levels. 

To  throw  our  problem  into  clearer  light,  it  may  be  repeated 
that,  in  the  absence  of  a  common  denominator  in  which  to  ex- 
press the  relative  values  of  the  two  moneys,  we  are  com- 
pelled to  derive  their  par  of  exchange  by  comparing  the  pur-;) 
chasing  power  of  one  with  that  of  the  other.  The  purchasing 
power  of  money  is,  of  course,  a  reciprocal  of  the  general  price 
level;  that  is  to  say,  when  all  prices  are  rising,  the  purchasing 
power  of  money  is  falling  pari  passu,  and  when  all  prices  are 
falling,  the  purchasing  power  of  money  is  rising  propor- 
tionately. Hence,  taking  England  and  the  United  States  as 
our  examples,  by  comparing  the  trend  of  the  price  level  in  the 
United  States  with  the  trend  of  the  price  level  in  England,  we 
can  compare  changes  in  the  purchasing  power  of  the  dollar 
with  similar  changes  in  the  purchasing  power  of  the  pound 
during  the  years  under  observation.  To  avoid  going  too  far 
afield  in  our  discussion  of  this  problem,  we  may  assume  that 
a  reliable  index  number  is  devised  which  makes  the  trend  of 
prices  in  the  two  countries  comparable  with  each  other.  If, 
now,  we  discover  by  using  this  index  that  the  price  level  in 
England  has  risen  twice  as  far  as  the  price  level  in  the  United 
States  since  1914,  or,  to  state  the  same  fact  in  another  man- 
ner, that  the  purchasing  power  of  the  pound  has  fallen  twice 
as  far  as  the  purchasing  power  of  the  dollar,  we  may  conclude 
that  half  as  many  dollars  are  now  required  to  express  the 
equivalent  of  the  pound  as  normally.  In  this  case  the  ratios 
of  the  two  price  levels  is  as  1:2;  and  the  old  par  of  exchange 
must  be  multiplied  by  this  fraction  to  bring  it  into  con- 
formity with  the  altered  purchasing  powers  of  the  two 
moneys.     While  these  conditions  remain  true,  the  par  of  ex- 


56  FOREIGN  EXCHANGE 

chancre  between  the  dollar  and  the  pound,  formerly  $4,8065 
per  £1,  becomes  $2A3S25  per  £l.i 

We  may  illustrate  this  method  of  obtaining  the  purchasing 
power  parities  of  different  coins  when  gold  has  ceased  to 
function  as  a  common  denominator  by  referring  to  the  trend 
of  prices  in  the  United  States  in  comparison  with  the  trends 
in  Italy,  France,  and  England  since  1913.  An  index  number, 
constructed  from  the  same  group  of  commodities  in  each 
country,  and  based  upon  a  common  year,  shows  the  following 
price  changes  at  the  end  of  the  year  1920: 

Base  year  Index  numbers 

Country  1913  December,  1920 « 

United  States 100  200 

Italy 100  650 

France 100  450 

England 100  250 

Prices  in  the  United  States  had  doubled  between  these  two 
dates;  in  Italy,  they  had  risen  six  and  one  half  times;  in 
France,  four  and  one  half  times;  and  in  England,  two  and  one 
half  times.  On  the  basis  of  these  facts,  how  can  we  deter- 
mine the  purchasing  power  parities  of  the  dollar  with  the  lira, 
the  franc,  and  the  pound,  respectively,  in  December,  1920? 
Assuming  that  the  gold  parities  and  the  purchasing  power 
parities  of  the  dollar  with  these  coins  were  identical  in  1913, 
we  correct  the  gold  parities  on  the  basis  of  the  difference  in 
the  price  changes  in  these  countries.    The  ratio  of  the  rise  of 

^  It  may  be  well  to  point  out  that  this  calculation  of  the  current  par  of 
exchange  with  a  nation  using  a  depreciated  paper  money  is  accurate  only  if 
based  upon  a  year  when  the  mint  parities  and  the  purchasing  power  parities 
of  the  two  coins  were  identical.  If  the  normal  par  of  exchange  failed  to  ex- 
press the  purchasing  power  parity,  a  fundamental  error  would  be  involved  in 
the  calculation  which  would  vitiate  its  results.  The  index  number  con- 
structed for  this  purpose  must  take  account  of  this  necessity. 

^  The  price  levels  in  all  countries  were  changing  rapidly  at  the  time  chosen 
for  illustration.  This  introduces  an  element  of  uncertainty  into  the  data 
from  which  the  index  numbers  were  computed.  Since  these  figures,  and  the 
conclusions  derived  from  them,  are  used  merely  for  purposes  of  exposition, 
it  has  been  thought  best  to  disregard  this  error  and  be  content  with  approxi- 
mate results. 


RATES  OF  EXCHANGE 


57 


prices  in  the  United  States  to  the  rise  of  prices  in  Italy,  as 
shown  by  the  table  above,  was  200:650;  with  respect  to 
France,  this  ratio  was  200:450;  with  respect  to  England, 
200:250.  These  ratios  are  equivalent  to  the  following 
fractions : 

United  States  and  Italy,  200:650  =  4/13 
United  States  and  France,  200:450  =  4/9 
United  States  and  England,  200:250  =  4/5 

The  gold  pars  of  exchange  are  corrected  to  conform  to  this 
condition  of  irredeemable  and  depreciated  paper  money  by 
multiplying  them  by  these  fractions,  as  follows : 


CounlTy 

Gold  par 
of  eiihnnge 
with  dollar 

Ratio  of  price 

changes  in  U.S. 

to  price  changes 

in  given  country 

lOli  to  Dec.  1920 

Purchasing  power 
par  icilh  dollar 
December,  t9H0 

Italy  

$  .193 
.193 
4.8665 

4/13 

4/9 
4/5 

$  .0593 

France 

.0857 

England 

3.8932 

In  the  general  confusion  of  the  exchange  market  which  re- 
sults from  the  collapse  of  the  monetary  systems  of  a  group 
of  countries,  misleading  conclusions  are  frequently  drawn 
regarding  the  effect  of  current  exchange  rates  upon  inter- 
national commerce.  The  exchange  market  quotes  bills  drawn 
in  depreciated  paper  at  rates  which  sometimes  register  ex- 
treme discounts  from  the  normal  gold  pars  and  no  attempt 
is  made  to  indicate  what  part  of  this  discount  is  a  true  dis- 
count —  that  is,  a  discount  from  tlie  new  i)ars  of  exchange  — 
and  what  part  is  to  be  attril)utcd  to  the  dislocation  of  the  old 
j)ars.  The  necessity  of  guarding  against  this  error  may  be 
illuslrated  with  reference  to  the  conditions  we  have  been  dis- 
cussing. On  December  10,  1!)20,  exchange  on  Italy  was 
quoted  in  New  York  at  .035;  exchange  on  France,  at  .0586; 
exchange  on  England,  at  3.4475  (these  quotations,  of  course, 


58 


FOREIGN  EXCHANGE 


are  expressed  in  units  of  the  dollar).  The  following  table 
contrasts  the  apparent  and  true  discounts  on  lira,  franc,  and 
sterlinij  exchange  registered  by  these  quotations  on  December 
10,  liHO: 


Country 

Rate  of  exchange 
Dec.  10.  l'J20 

Purchasing  jxrwer 
par  of  exchange 

Current  (fimtation 

discount  from 

gold  par 

(per  cent) 

Current  rfuotation 

discount  from 

purchasing/ 

power  par 

(per  cent) 

Italy 

France .... 
England. . . 

$   .035 
.058 
3.4475 

$.0593 

.0S57 

3.8932 

81.8 

70. 

29.1 

40.9 
32.4 
11.5 

The  last  two  columns  of  the  table  give  the  percentage  of  dis- 
count below  the  gold  par  and  the  purchasing  power  par  shown 
by  the  rates  of  exchange  on  the  date  given.  It  will  be  seen 
at  once  that,  although  bills  drawn  in  lire,  francs,  and  pounds 
sold  at  a  true  discount  on  this  date,  the  discount  was  less  than 
half  as  great  as  might  have  been  inferred  from  a  comparison 
of  the  quotations  wath  the  nominal  pars  for  these  moneys. 
This  subject  of  the  effect  of  a  depreciated  paper  upon  the 
rates  of  exchange  has  been  given  a  somewhat  lengthy  treat- 
ment because  of  the  great  importance  at  the  present  time, 
and  the  promise  of  continued  importance  in  the  near  future, 
of  correct  thinking  upon  this  matter.  In  a  later  chapter,^ 
it  will  be  shown  that  fluctuations  of  the  rates  of  exchange 
exert  a  stimulating  or  depressing  influence  over  the  export 
and  import  trade  of  a  nation;  failure  to  distinguish  between 
true  fluctuations  of  the  rates  and  movements  of  the  pars  of 
exchange  under  the  influence  of  the  money  factor  has  in- 
duced many  countries  to  adopt  ill-conceived  and  mis- 
chievous policies  of  interference  in  the  currents  of  inter- 
national commerce.  For  the  sake  of  additional  emphasis,  a 
graphic  illustration  is  given  on  page  59  of  the  tendency  of 
the  exchange  rates  to  conform  to  the  purchasing  power 
parities  of  the  different  national  moneys.  The  fact  that  the 
1  See  Chapter  V. 


RATES  OF  EXCHANGE 


59 


Forms 

Dia'RECiATioN  OP  Foreign  Exchange  compared  with  Depreciation  op 
Foreign  Currency 

The  par  line  represents  the  value  of  the  dollar;  the  quotations  on  for- 
eign exchange  are  plotted  as  percentages  of  the  normal  par  with  the  dollar; 
the  purchasing  power  of  the  foreign  currency  is  plotted  as  a  percentage 
of  the  purchasing  power  of  the  dollar. 

The  solid  line,  therefore,  represents  the  purchasing  power  parity  of  the 
dollar  with  the  given  foreign  currency;  the  broken  line  should  be  compared 
with  this. 


Par 

20? 

4o: 
60:; 

lOOS 


1919 


1920 


1921 


England 
--—  Exchange  quotations 
Purchasing  power  of  currency 


Par 

20? 

4o; 

60S 
1002 


^s 

I 
\ 

A 

^'\.''       ^-^^       /" 


1919 


1920 


1921 


France 

— —  Exchange  quotations 

Purchasing  power  of  currency  ' 


Par 

202 

402 
602 
802 
1002 


\ 
\ 
1 

''""V 

X 

\  .r. 

"n, 

'       > 

1919 


1920 


1921 


Par 
202 
402 
602 
802 
1002 


,    y 

> . 

: 

Italy 

_-»-  Exchange  quotations 

— ^  Purchasing  power  of  currency 


1919 


1921 


1920 

Germany 

""— —  Exchange  quotations 

—^—  Purchasing  power  of  currency 


60  FOREIGN  EXCHANGE 

discount  on  lira,  fmiic,  mark,  and  sterling  exchange,  as 
slunvn  hy  the  broken  curves,  tended,  during  the  period  re- 
vieweil  in  the  ilhislration,  to  conform  to  the  chan<j;es  in  the 
purchasing  j)owcr  parities  of  these  moneys  with  the  dollar, 
as  shown  by  the  solid  curves,  is  evidence  that  the  gold  pars 
of  exchange  no  longer  apply  when  a  nation's  standard  money 
is  an  irredeemable  j)apcr. 

In  summarizing  this  discussion,  it  may  be  said  that  there 
are  two  possible  ways  of  determining  par  of  exchange  between 
a  gold  standard  and  a  paper  standard  country:  (a)  a  cor- 
rection of  the  gold  par  by  utilizing  the  premium  on  gold  in 
the  i)aper  country;  (b)  a  correction  of  the  gold  par  by  multi- 
plying it  by  the  ratio  of  the  purchasing  power  of  the  gold  coin 
to  the  purchasing  power  of  the  irredeemable  paper,  both  pur- 
chasing powers  being  derived  from  a  common  index  number. 
Sul)stantially  accurate  results  may  be  obtained  from  the  first 
method  when  the  paper  money  has  not  long  been  depreciated 
and  gold  is  available  for  exportation  in  the  paper  standard 
country.  When  depreciation  of  the  paper  has  run  to  ex- 
treme lengths,  and  the  paper  standard  country  cannot  supply 
gold  for  exportation,  the  second  method  will  give  the  more 
accurate  results.  It  may  be  added  that  between  two  paper 
standard  countries,  the  only  reliable  method  of  determining 
par  of  exchange  is  the  purchasing  power  method. 

i6.  Market  fluctuations  of  the  exchange  rates.  So  rarely 
are  bills  of  exchange  bought  and  sold  at  par  in  the  market 
that  many  business  men  who  have  daily  transactions  involv- 
ing the  purchase  and  sale  of  foreign  bills  are  ignorant  of  the 
fact  that  fixed  pars  exist.  What  has  been  called  the  location 
factor  of  the  foreign  bill  —  that  is  to  say,  the  power  of  the 
bill  to  increase  or  diminish  the  holder's  supply  of  funds  in 
different  geographical  centers  —  so  influences  its  desirability 
to  buyer  and  seller  as  to  prevent  its  changing  hands  upon 
terms  which  express  equality  between  the  two  systems  of 
coinage.  It  is  this  fluctuating  desirability  of  foreign  funds 
which  accounts  for  the  daily  fluctuations  of  the  exchange 
rates. 

In  explanation  of  the  influence  of  this  factor  upon  the  daily 


RATES  OF  EXCHANGE  61 

quotations  of  exchange  rates,  let  us  return  to  the  effect  upon 
the  relations  of  the  bankers  caused  by  the  buying  and  selling 
of  sterling  bills  in  the  New  York  market.  When  a  banker 
in  New  York  buys  a  sterling  bill  of  exchange,  he  virtually 
transfers  a  portion  of  his  funds  to  London;  when  he  sells  a 
sterling  bill,  he  returns  these  funds  to  his  own  vaults.  Now, 
it  is  obvious  that  the  only  motive  which  can  cause  a  New 
York  banker  to  place  funds  in  London  will  be  the  desire  to 
make  a  profit  by  employing  them  there;  and  in  foreign  ex- 
change this  employment  takes  the  form  of  bills  drawn  against 
the  fund  and  sold  in  the  bankers'  market.  Hence  the  desir- 
ability to  the  banker  of  a  sterling  bill  which  will  increase  the 
amount  of  his  London  credit  will  depend  upon  his  oppor- 
tunities for  selling  sterling  demand  drafts  in  New  York.  If 
his  London  balance  is  outstripping  the  market  for  his  sterling 
drafts,  he  will  be  reluctant  to  buy  and  eager  to  sell  bills 
drawn  on  London ;  while  if  the  reverse  is  true  and  he  finds  his 
London  balance  lagging  behind  the  market  for  his  sterling 
drafts  in  New  York,  he  will  be  eager  to  increase  the  balance 
by  buying  bills  and  slow  to  deplete  it  still  further  by  selling 
his  own  drafts.  It  is  customary  to  say  that  the  rate  of  ex- 
change in  the  New  York  market  from  day  to  day  is  regulated 
by  the  supply  and  demand  of  bills  of  exchange.  This  is  true; 
for  it  is  the  supply  of  sterling  bills  offered  for  sale  to  New  York 
bankers  which  creates  the  London  credit,  and  it  is  the  de- 
mand for  bankers'  drafts  which  determines  the  profitable 
employment  of  the  credit;  hence  the  relation  of  supply  to 
demand  is  the  deciding  factorlri  the  banker's  evaluation  of  a 
given  foreign  bill  of  exchange. 

If  the  exporters  of  goods  to  England  could  offer  sterling 
bills  on  the  New  York  market  in  amounts  substantially  equal 
from  day  to  day  to  the  demand  of  the  importers  for  bankers* 
sterling  drafts,  London  credits  could  be  utilized  as  rapidly  as 
they  accrued,  and  so  would  never  grow  unduly  large  or  unduly 
small.  But  no  such  equation  of  supply  to  demand  can  be 
maintained  over  long  periods  of  time,  for  each  is  subject  to 
seasonal  fluctuations  peculiar  to  itself.  The  supply  of  sterling 
bills  arises  in  greatest  volume  during  the  late  fall  and  early 


62  FOREIGN  EXCHANGE 

winter  wlion  our  cxjiorls  of  foodstiifTs  and  raw  materials  are 
lieaviesl ;  while  the  demand  for  bankers'  drafts  —  these  being 
iisctl  to  efTeet  payments  due  in  widely  separated  markets  for 
importations  of  various  goods  and  services  —  does  not  co- 
inride  with  variations  in  the  supply  of  commercial  bills. 
There  are  periods  of  the  year,  therefore,  when  the  New  York 
bankers  are  building  up  large  balances  in  London  against 
which  they  have  relatively  few  opportunities  to  draw,  and 
other  periods  when  these  balances  are  being  drawn  down 
more  rapidly  than  the  bankers  can  repair  them  through  the 
purchase  and  remittance  of  sterling  bills.  Under  the  former 
of  these  conditions,  the  bankers  will  be  more  eager  to  sell 
than  to  buy  and  the  rate  of  exchange  will,  consequently,  fall 
below  par;  under  the  latter,  they  will  be  more  eager  to  buy 
than  to  sell  and  the  rate  wull  rise  above  par. 

The  practice  of  the  exchange  market  has  resulted  in  the 
adoption  of  a  definite  scale  of  steps  or  gradations  in  which 
quotations  above  or  below  par  are  expressed.  For  years  the 
bankers  in  New  York  raised  and  lowered  the  prices  asked  for 
their  sterling  demand  drafts  in  gradations  of  1/8  cent  per 
pound.  Thus,  starting,  let  us  say,  from  4.86,  the  rates  would 
be  raised  through  the  series:  4.86  1/8;  4.86  1/4;  4.86  3/8, 
etc.;  and  lowered  through  the  series:  4.85  7/8,  4.85  3/4, 
4.85  5/8,  etc.  At  the  present  time,  however,  a  departure 
from  this  method  of  quoting  sterling  is  making  its  appearance 
in  certain  financial  journals.  The  scale  employed  is  expressed 
in  decimal  form  and  rises  and  falls  by  gradations  of  $.005  per 
pound.  For  example,  beginning  at  par,  4.8665,  quotations 
rise  in  the  decimal  quotation  through  the  series:  4.8670, 
4.8675,  4.8680,  etc.;  and  fall  through  the  series:  4.8660, 
4.8655,  4.8650,  etc.  This  change  in  the  method  of  quoting 
sterling  exchange  amounts,  of  course,  to  splitting  the  former 
scale  into  finer  gradations,  thus  making  possible  a  nicer  ad- 
justment of  bid  to  offer  under  competition.  For  this  reason, 
and  because  it  is  somewhat  less  cumbersome  than  the  older 
fractional  quotation,  the  more  recent  practice  seems  prefer- 
able.    The  older  form,  however,  still  survives  in  the  market. 

In  a  similar  manner,  custom  has  prescribed  a  more  or  less 


RATES  OF  EXCHANGE  68 

rigid  system  of  quotations  for  other  bills  than  sterling.  In 
franc  exchange,  the  case  is  somewhat  complicated  by  the  fact 
that  par,  itself,  is  expressed  in  two  different  ways:  either  in 
francs  per  dollar  (par  is:  5.1826  francs  equal  one  dollar)  or  in 
cents  per  franc  (par  is:  19.3^  equal  one  franc).  When  par  is 
expressed  in  the  latter  form,  the  rate  rises  and  falls  in  grada- 
tions on  l/lO^  per  franc;  when  the  former,  and  older  method, 
of  quoting  par  is  employed,  it  is  the  custom  to  vary  the  quo- 
tations by  intervals  of  5/8  centime  each.  Thus,  starting  at 
5.18,  the  rates  rise  through  the  series:  5.17  1/2,  5.16  7/8, 
5.16  1/4,  etc.;  and  fall  through  the  series:  5.18  3/4,  5.19  3/8, 
5.20,  etc.  It  should  be  repeated,  perhaps,  that  in  this  case 
the  higher  figure  means  the  lower  rate  and  vice  versa.  A 
change  in  the  quotation  from  5.17  1/2  to  5.18  3/4,  for  example, 
indicates  that  each  dollar  will  buy  .01  1/4  more  francs  than 
formerly,  or  that  franc  bills  have  become  cheaper,  while  a 
reverse  change  of  equal  amount  means  that  franc  bills  have 
grown  correspondingly  dearer. 

As  in  sterling  exchange,  there  has  been  an  attempt  to  re- 
solve franc  quotations  into  a  series  of  finer  gradation,  but 
the  method  employed  is  somewhat  cumbersome  and  confusing. 
The  old  scale  with  its  variations  of  5/8  centime  is  retained, 
and  a  dealer  wishing  to  quote  a  rate  between  any  two  steps 
in  the  scale  does  so  by  offering  a  rebate  or  charging  a  premium 
of  a  fraction  of  one  per  cent  on  the  face  of  the  bill.  Quota- 
tions such  as  the  following  are  sometimes  to  be  seen:  5.18  3/4 
plus  1/32;  5.18  3/4  minus  1/16.  The  former  of  these  quo- 
tations represents  a  banker's  offer  to  sell  a  demand  draft  at 
the  rate  5.18  3/4  francs  per  dollar,  with  an  additional  charge 
of  1/32  per  cent  upon  the  sum  total  of  the  bill.  Such  a  draft 
for  51,875  francs  would  cost  $10,000  (51,875  ~  5.1875)  plus 
1/32  per  cent  of  $10,000,  or  a  total  of  $10,003.12.  At  the 
second  rate,  the  same  bill  would  cost  $10,000  minus  1/16  per 
cent  of  $10,000,  or  $9993.75.  Conventions  similar  to  these 
control  the  quotations  on  bills  drawn  in  other  moneys.  Ger- 
man and  Dutch  exchange  are  quoted  in  gradations  of  1/8]!^ 
per  mark  or  guilder,  sometimes  with  additional  charges  or 
rebates  as  in  the  case  of  franc  bills.     Exchange  on  Switzer- 


64  FOREIGN  EXCHANGE 

land.  Italy,  Belgium,  and  Greece  is  quoted  in  like  manner  with 

rxfhan<:o  on  Fr;yicc. 

17.  The  s^cie  points.  The  exchange  rates  cannot  rise 
or  fall  indofinitoly.  Except  when  conditions  of  the  exchange 
market  are  abnormal,  a  somewhat  rigid  limit  is  imposed  be- 
yond which  the  discount  or  premium  cannot  go,  and  this 
limit  has  the  effect  of  confining  the  fluctuations  of  the  rates 
within  a  rather  narrow  range.  The  point  at  which  the  rise 
or  fall  of  the  exchange  rates  will  stop  is  determined  by  the 
cost  of  shipping  specie  from  one  market  to  the  other.  On 
sterling  exchange,  for  example,  the  premium  per  pound  can- 
not be  more  than  the  cost  of  shipping  from  New  York  to  Lon- 
don enough  gold  to  make  a  pound;  nor  can  the  discount  ex- 
ceed the  cost  of  bringing  from  London  to  New  York  the  gold 
content  of  one  pound.  Because  of  their  relation  to  the  cost 
of  transporting  gold,  the  maximum  and  minimum  quotations 
are  called  the  specie  exporting  and  the  specie  importing  points 
respectively. 

The  movement  of  gold  in  or  out  of  the  country  is  effective 
in  stopping  the  decline  or  the  rise  of  the  rates  of  exchange 
because  it  removes  the  cause  of  the  decline  or  the  rise.  As 
we  have  seen,  the  force  which  drives  the  sterling  rate  below 
par  is  an  excess  supply  of  sterling  bills,  whose  immediate 
effect  is  to  cause  the  London  balances  of  New  York  banks 
to  grow  disproportionately  large.  A  continuation  of  this 
condition  will  force  New  York  bankers,  who  have  trans- 
ferred large  amounts  of  their  available  funds  to  London 
through  the  purchase  of  commercial  bills,  to  instruct  their 
English  correspondents  to  remit  a  part  of  these  funds  in 
bullion.  But  the  shipment  of  gold  is  an  expensive  operation, 
and  to  avoid  it  the  bankers  will  endeavor  to  sell  every  pos- 
sible sterling  draft  against  their  London  credits;  for  by  so 
doing,  they  will  realize  upon  these  credits  in  dollars  and  cents 
without  the  expense  of  importing  gold.  If  lowering  the  rate 
of  exchange  will  avail  to  sell  more  drafts,  the  rate  will  be 
lowered,  but  not  indefinitely;  for  a  point  will  be  reached  be- 
yond which  the  loss  in  discount  will  be  greater  than  the  ex- 
pense per  pound  of  importing  specie  (the  bankers'  alterna- 


RATES  OF  EXCHANGE  66 

tive  method  of  realizing  upon  their  London  credits),  and  to 
push  the  rate  lower  would  be  to  adopt  the  more  expensive 
means  of  transferring  London  balances  to  the  vaults  of  the 
New  York  banks.  When,  therefore,  the  sterling  rate  has 
fallen  to  the  point  at  which  the  seller  is  losing  as  much  from 
the  face  of  his  bill  as  he  would  lose  by  paying  the  cost  of 
transporting  the  gold  in  which  it  will  be  cashed  in  London, 
the  supply  of  bankers'  bills  will  disappear  from  the  market. 
Foreign  correspondents  who  hold  the  bankers'  balances  will 
be  instructed  to  ship  the  amount  due  in  the  form  of  gold 
bullion.  On  the  other  hand,  at  this  point,  or  very  slightly 
below  it,  the  bankers  will  buy  an  unlimited  amount  of  sterling 
commercial  bills,  regardless  of  the  condition  of  their  London 
balances;  for  at  rates  so  low,  the  buyers  can  afford  to  collect 
the  proceeds  of  the  bills  in  specie,  box,  insure,  and  ship  the 
gold  to  New  York  and  still  make  a  profit  from  the  trans- 
action. This,  then,  is  the  specie  importing  point;  under 
normal  conditions,  the  fact  that  sterling,  or  other  foreign, 
rates  are  standing  at  this  point  is  sufficient  proof  that  New 
York  is  drawing  gold  from  the  foreign  center  in  question. 
Reviewing  what  has  been  said  in  this  paragraph,  it  should  be 
clear  that  the  decline  in  the  rate  is  stopped  at  the  specie 
importing  point  by  the  removal  of  its  cause:  that  is,  by 
wiping  out  the  supply  of,  and  increasing  the  demand  for, 
sterling  bills. 

By  a  similar  force,  the  rise  of  the  rates  of  exchange  is  stopped 
at  the  specie  exporting  point.  A  premium  appears  when  the 
demand  for  bankers'  bills  is  excessive  in  comparison  with  the 
supply  of  commercial  bills  with  which  to  strengthen  the  for- 
eign balances;  for  under  this  condition,  the  credits  of  the  New 
York  bankers  in  foreign  money  centers  will  ai)proach  ex- 
haustion, and  the  power  to  draw  more  demand  drafts  will  be 
sharply  curtailed.  If  the  demand  continues  unchecked,  the 
competing  buyers  of  bankers'  bills  will  bid  up  the  rate  until 
the  cost  in  premium  is  as  great  as  the  cost  of  exporting  gold 
to  the  foreign  center.  At  a  rate  slightly  above  this  point,  an 
unlimited  supply  of  bankers'  bills  will  appear  on  the  market; 
for  with  so  great  a  premium,  the  bankers  can  afford  to  ship 


66  FOREIGN  EXCHANGE 

to  Ix)nclon  and  other  cities  gold  enough  to  redeem  every  bill 
they  draw,  paying  all  the  costs  of  the  transaction,  and  yet 
make  a  profit.  The  buyers  of  bankers'  bills,  on  the  other 
hand,  have  always  open  to  them  the  alternative  of  making 
their  remittances  in  specie,  and  they  will  begin  to  avail  them- 
selves of  this  alternative  if  the  premium  on  the  bills  much 
exceeds  the  cost  of  shipjnng  the  gold.  Thus  the  limit  to  the 
premium  on  foreign  bills  of  exchange  is  fixed  at  the  specie 
exi)orting  point. 

i8.  Determination  of  the  specie  points.  The  specie  points 
are  not  absolutely  rigid,  varying  in  harmony  with  variations 
in  the  different  items  which  make  up  the  cost  of  shipping 
s])ecie.  No  form  of  money  possesses  international  purchasing 
power  except  gold;  and  in  international  trade,  gold  money  is 
taken  by  weight  and  not  by  tale  or  count.  The  shipment 
may  be  made  in  the  form  of  gold  coin  or  of  gold  bars  with 
slightly  different  costs  in  each  instance.  To  illustrate  the 
method  of  computing  the  specie  export  point  in  sterling  ex- 
change, let  us  take  a  standard  transaction  involving  the 
shipment  of  $100,000  in  United  States  gold  coin  from  New 
York  to  London. 

Cost  of  Shipping  $100,000  in  U.S.  Gold  Com,  New  York  to 

London 

Cooperage,  two  casks  @  $3.50 $    7.00 

Cartage 8.00 

Freight,  l3^  per  cent  of  value 150.00 

Interest,  three  days  @  6  per  cent 50.00 

Insurance,  @  50^  per  thousand 50.00 

Total  shipping  costs $265.00 

This  gold  may  be  obtained  by  presenting  at  the  Subtreasury 
in  New  York  $100,000  in  gold  certificates;  their  value  must 
be  added. 

Shipping  costs,  as  above $        265.00 

Value  of  coin  in  New  York 100,000.00 

Total  cost  of  the  shipment $100,265.00 

It  is  assumed  that  the  shipping  costs  in  the  above  compu- 
tation are  self-explanatory  wuth  the  exception  of  the  interest 


RATES  OF  EXCHANGE  67 

item.  This,  it  will  be  noted,  is  computed  for  three  days, 
which,  obviously,  is  not  the  length  of  time  consumed  in  the 
passage  of  the  steamer  across  the  Atlantic.  However,  the 
banker's  loss  of  interest  is  not  governed  by  the  steamer's 
passage,  but  by  the  interval  of  time  which  elapses  between 
his  withdrawal  of  $100,000  in  gold  certificates  from  his  vaults 
and  the  recovery  of  these  funds  through  the  sale  of  a  demand 
draft  against  the  shipment.  It  is  even  possible  for  the 
banker  to  avoid  loss  of  interest  entirely  by  selling  his  demand 
draft  at  the  time  he  withdraws  the  gold  from  the  Sub- 
treasury.  If  the  draft  and  the  gold  go  forward  by  the  same 
steamer,  the  gold  will  arrive  in  London  in  time  to  redeem  the 
draft.  But  complete  avoidance  of  interest  cost  is  not  often 
possible.  If  the  steamer  sails  in  the  forenoon,  the  gold  must 
be  put  aboard  the  day  before;  the  purchaser  of  the  demand 
draft  will  have  made  his  arrangements  with  the  banker  some 
time  in  advance,  agreeing  to  pay  by  check  on  the  day  of  sail- 
ing; the  check  may  have  to  be  sent  through  the  Clearing 
House  on  the  day  following  before  the  banker's  cash  reserve 
is  increased  by  the  sale  of  the  draft.  Interest  will,  conse- 
quently, be  lost  from  the  moment  the  gold  certificates  are 
withdrawn  on  the  day  preceding  the  sailing  until  the  proceeds 
of  the  check  return  from  the  Clearing  House  on  the  day  fol- 
lowing the  sailing.  In  actual  practice,  this  interval  of  time 
varies  considerably  as  between  different  transactions;  the 
maximum  is  rarely  more  than  three  days,  and  the  minimum 
may  be  anything  less  than  this,  or  nothing  at  all.  The  New 
York  rate  of  interest  is  used  in  computing  the  loss  of  interest, 
since  it  is  here  the  banker's  funds  would  have  been  employed 
if  they  had  not  been  expended  in  the  purchase  of  gold. 

Returning,  now,  to  our  task  of  determining  the  specie 
point,  we  may  proceed  from  the  fact  that  it  has  cost  the  New 
York  banker  $100,265  to  place  ten  thousand  gold  eagles  in 
London.  The  banker's  drafts  against  this  gold  will  be  drawn 
in  pounds  sterling,  and  the  total  amount  that  he  can  draw 
will  depend  upon  how  much  credit,  stated  in  pounds,  this 
shipment  will  give  him  in  London.  The  Bank  of  England 
is  ready  at  all  times  to  buy  gold  coin  of  the  fineness  of  the 


68  FOm:iGN  EXCILVNGE 

riiitcd  States  eagle  (9/10  fine)  at  the  i)rice  which  hovers 
al)i)ut  7(!.v.  Ul.  per  ounce.  Ten  thousand  new  gold  eagles  con- 
tain 2,.5S(),()00  grains  of  gold,  nine  tenths  fine;  but  these  coins 
will  not  have  been  entirely  full  weight  at  the  time  they  were 
obtained  from  the  Subtreasury,  and,  furthermore,  abrasion 
in  transit  will  have  still  further  reduced  their  weight  before 
they  are  offered  to  the  Bank  of  England.  For  these  reasons, 
we  may  allow  a  loss  of  l/lO  per  cent,  or  2580  grains;  our  com- 
putation, then,  takes  the  following  form: 

Sterling  Credit  Created  by  Shipping  10,000  Gold  Eagles,  New 
York  to  London 

10.000  gold  eagles,  full  weight 2,580,000  grains,  9/  10  fine 

Subtract  loss  in  weight,  1/10  per  cent. .  2,580  grains 

Weight  of  gold  offered  to  Bank  of  Eng-  

land 2,577.420  grains,  9/10  fine 

2.577,420  grains  is  5369.62  ounces 
Bank's  price  is  76s.  ^d.  per  ounce 
5369.G2  ounces  @  76/4  equals  £20,494.05 

Total  sterling  credit  in  London £20,494  Is. 

By  shipping  ten  thousand  gold  eagles  to  London  and  selling 
them  to  the  Bank  of  England,  the  banker  in  New  York  has 
gained  the  power  to  draw  sterling  demand  drafts  totaling 
£20,494  Is.  The  total  cost  of  this  credit  was  $100,265; 
hence  it  has  cost  per  pound,  $4.8918.  This  is  the  specie 
exporting  point  on  sterling  exchange;  by  selling  his  drafts  at 
this  rate,  the  banker  will  receive  exactly  what  it  costs  him  to 
create  the  credit,  including  in  the  cost  the  value  of  the  gold 
he  has  shipped.  If  the  rate  rises  even  slightly  above  this 
point,  an  unlimited  supply  of  sterling  demand  drafts  wil? 
appear  on  the  market;  each  may  be  covered  in  gold  by  the 
draA\nng  banker,  yet  the  transaction  will  return  him  a  profit. 
The  specie  exporting  point  and  the  upper  limit  to  the  sterling 
rates  will  hover  about  4.8918  so  long  as  the  shipping  costs 
remain  unchanged. 

The  costs  of  importing  specie  are  fixed  by  the  same  prin- 
ciples as  those  just  discussed,  but  with  some  slight  variation 


RATES  OF  EXCHANGE  69 

in  the  individual  items.  Normally,  English  gold  sovereigns 
or  gold  bars  of  a  certified  fineness  may  be  bought  from  the 
Bank  of  England  at  fixed  rates;  and  it  is  usually  possible, 
also,  to  buy  United  States  goiu  eagles  which  have  been  stored 
there  as  the  result  of  gold  shipments  from  this  side.  In  any 
case,  the  gold  must  be  bought  by  weight.  If  bars  or  English 
coins  are  imported,  these  must  be  sold  by  weight  to  the  assay 
ofiice  in  New  York,  and  the  importer  must  bear  all  loss 
through  abrasion.  If  the  shipment  is  composed  of  United 
States  coin,  the  money  may,  of  course,  be  added  directly  to 
the  cash  reserves  of  the  importing  bank  and  loss  through 
abrasion  may  be  avoided.  Most  of  the  shipping  costs  —  for 
instance,  insurance,  cartage,  freight,  cooperage  —  are  prac- 
tically identical  for  movements  of  gold  in  both  directions. 
But  there  is  a  striking  difference  in  the  interest  item :  the  max- 
imum loss  is  about  twenty  days  when  gold  is  imported  by 
New  York  bankers  from  London,  and  not  more  than  three 
days  when  gold  is  exported  to  London.  In  each  case,  the  loss 
is  measured  by  the  interval  of  time  which  must  elapse  be- 
tween the  withdrawal  of  funds  from  the  banker's  vaults  in 
preparation  of  the  gold  shipment,  and  the  return  of  these 
funds  as  a  consequence  of  the  gold  shipment.  When  export- 
ing gold,  the  outgo  and  income  to  the  banker  may  occur 
almost  simultaneously,  since  the  sale  of  the  demand  draft 
which  covers  the  gold  shipment  follows  closely  upon  the  with- 
drawal of  the  gold,  itself. 

However,  when  gold  is  imported  the  banker  is  deprived  of 
the  use  of  his  money  for  a  longer  period.  He  must  first 
obtain  the  specie  from  the  Bank  of  England,  and  this  he  does 
by  sending  over  a  credit  instrument  payable  in  gold.  This 
instrument  is  usually  a  sterling  demand  draft;  the  importing 
banker  buys  it  in  New  York,  and  sends  it  to  London  to  be 
cashed  in  gold  or  in  Bank  of  England  notes  which  are  redeem- 
able in  gold.  The  gold  is  shipped  and  the  banker  must  await 
the  arrival  of  the  steamer  which  brings  it.  The  outgo  of 
funds  occurs  when  the  draft  is  bought;  the  income,  not  until 
the  shipment  has  arrived  and  has  been  turned  into  United 
States  money.     Thus  interest  is  lost  during  the  time  con- 


70  FOREIGN  EXCHANGE 

sunicd  in  both  voyages  to  and  from  London  plus  whatever 
interval  elapses  between  the  arrival  of  the  steamer  which 
carries  the  demand  draft  to  London  and  the  departure  of  the 
steamer  which  brings  the  gold.  This  period  of  time  may  be 
reduced  l)y  about  ten  days  if  a  sterling  cable  is  used  in  place 
of  a  sterling  demand  draft  for  the  purpose  of  obtaining  gold 
in  London. 

In  illustration  of  these  principles,  let  us  assume  that  a 
banker  in  New  York  imports  the  ten  thousand  gold  eagles 
which  figured  in  our  previous  illustration,  obtaining  them 
from  the  Bank  of  England  at  the  selling  price  of  76^.  Id.  per 
ounce  and  using  a  demand  draft  for  this  purpose.  These 
gold  pieces  were  assumed  to  be  l/lO  per  cent  light  in  weight, 
which  brought  their  total  weight  down  to  53(r9.62  ounces. 
Under  these  conditions  the  calculation  of  the  specie  importing 
point  proceeds  as  follows: 

Cost  of  10,000  Gold  Eagles  at  Bakk  of  England's  Selling 

Price 
5369.62  ounces  standard  gold  ®  76/7  per  ounce £20561.17 

The  eagles  will,  of  course,  be  worth  $100,000  upon  arrival; 
let  us  assume  the  same  shipping  costs  as  before  with  the 
exception  of  the  interest  loss,  which  we  will  assume  to  be 
twenty  days  at  5  per  cent. 

Net  Receipts  from  Importing  10,000  Gold  Eagles,  London  to 

New  York 

Value  of  the  gold  upon  arrival $100,000 

Subtract  shipping  costs: 

Cooperage,  cartage,  freight,  insurance  $265 
Interest  at  5  per  cent  for  20  days ....      274 

Total 539 

Net  receipts  of  importation $99,461 

At  the  cost  of  £20,561.17  the  banker  has  obtained  $99,461; 
this  gives  a  rate  per  pound  of  $4.8373  (99,461  h-  20,561.17). 
Under  the  conditions  assumed,  therefore,  the  specie  importing 
point  in  New  York  is  4.8373. 


RATES  OF  EXCHANGE  71 

In  practice,  the  correspondent  banks  in  New  York  and 
London  which  engage  in  the  business  of  shipping  gold  arrange 
between  themselves  to  carry  through  the  transaction  upon 
the  cheapest  possible  terms,  and,  among  other  things,  to  re- 
duce the  interest  cost  as  much  as  possible,  by  using  the  most 
economical  means  of  obtaining  the  gold.  International  ship- 
ment of  gold  is  a  business  handled  almost  entirely  by  a  few 
specialists,  a  small  number  of  the  larger  finance  houses  with 
international  connections  and  with  all  facilities  for  reducing 
the  cost  of  the  business.  It  is  conducted,  as  is  every  other 
commercial  transaction,  solely  for  a  profit.  Those  who  en- 
gage in  the  business  are  governed  by  the  circumstances  of  the 
moment,  computing  the  costs  according  to  the  rates  of  freight, 
insurance,  interest,  and  the  price  of  gold  which  obtain  at  the 
time,  and  from  these  costs  computing  the  quotation  on  their 
demand  drafts  which  will  return  them  a  profit  when  the 
draft  must  be  covered  with  specie.  Since  each  of  these  costs 
is  somewhat  variable,  the  specie  points  show  a  certain  amount 
of  elasticity;  they  are,  nevertheless,  effective  in  limiting  the 
fluctuations  of  the  rates  of  exchange,  at  any  given  time,  by 
removing  the  cause  of  a  premium  or  a  discount. 

The  specie  points  on  franc,  mark,  yen,  and  other  bills 
drawn  on  gold  standard  countries  are  determined  by  the 
principles  which  have  been  discussed  with  reference  to  sterling 
exchange.  There  are  obvious  variations  in  the  items  em- 
braced in  the  calculation  due  to  differences  in  the  shipping 
and  interest  costs  between  New  York  and  these  different 
foreign  centers.  Less  obvious  variations  arise  from  differ- 
ences in  the  terms  upon  which  gold  can  be  bought  and  sold 
in  the  markets  abroad.  The  central  banks  of  these  markets 
offer  buying  and  selling  prices  for  bar  gold  and  foreign  gold 
coin  which  are  subject  to  some  slight  variation  from  time  to 
time  within  each  market,  and  which  differ  as  between  mar- 
kets as  the  coinage  laws  of  the  countries  differ.  But  it  is  not 
essential  to  our  purpose  to  enter  into  this  technical  detail; 
in  each  case,  governed  by  the  conditions  of  the  time  and 
place,  the  specie  points  on  the  exchange  rates  between  gold 
standard  countries  are  determined  by  the  costs  of  shipping 


78  FOKETGN  EXCHANGE 

gold  between  the  points  involved  in  the  rate.  In  precisely 
the  snnie  manner,  the  sj^ecie  points  on  exchange  between 
two  silver  standard  conutries  are  determined. 

19.  The  gold  exchange  standard.  The  subject  of  the  gold 
exchange  standard  has  been  reserved  for  discussion  at  this 
point,  although  it  is  here  somewhat  out  of  its  logical  position. 
This  standard  has  been  adopted  by  certain  countries,  for- 
merly on  the  silver  standard  of  coinage,  which  liave  desired  to 
stabilize  the  exchange  relations  between  their  silver  coins  and 
the  gold  coins  of  other  nations  by  utilizing  the  market  for 
foreign  bills  of  exchange.  Adequate  explanation  of  this 
standard  presupposes  a  knowledge  of  the  principles  under- 
lying the  specie  points. 

As  explained  on  another  page  in  this  chapter,  there  can  be 
no  fixed  par  of  exchange  between  a  silver  and  a  gold  standard 
country  so  long  as  the  standard  coins  of  each  are  influenced 
by  the  fluctuating  values  of  the  two  metals  of  which  they  are 
composed.  Since  each  metal  fluctuates  in  value  independ- 
ently of  the  other,  fixed  quantities  of  the  two  metals  (rep- 
resented by  the  standard  coins  of  the  two  countries)  cannot 
long  remain  equal  in  value.  Such  unstable  pars  of  exchange 
cause  abrupt  and  non-predictable  changes  in  the  market 
rates  of  exchange  quoted  in  gold  standard  countries  on  bills 
drawn  in  silver,  and  vice  versa,  which  increase  the  difficulties 
of  carrying  on  commercial  and  financial  transactions  between 
the  two  markets.  These  uncertainties  and  the  depressing 
influence  which  they  exert  upon  international  commerce,  pro- 
vide the  motive  which  has  induced  silver  standard  countries 
to  adopt  the  gold  exchange  standard. 

The  first  step  in  the  direction  of  giving  a  silver  coin  a  stable 
exchange  value  in  terms  of  gold  is  to  break  the  connection 
between  the  value  of  the  silver  coin  and  the  value  of  the 
metal  of  which  it  is  composed.  The  reason  why  any  stand- 
ard coin  rises  and  falls  in  value  in  close  harmony  with  fluctua- 
tions in  the  value  of  its  metal  content  —  why,  for  example, 
the  value  of  the  gold  dollar  moves  in  harmony  with  that  of 
gold  bullion,  and  the  value  of  the  silver  tael  in  harmony  with 
that  of  silver  bullion  —  is  because  the  mints  are  open  to  free 


RATES  OF  EXCHANGE  73 

coinage.  When  a  metal  may  be  coined  in  unlimited  amounts 
upon  fixed  terms  and  the  coins  may  be  reduced  to  metal  at 
any  time  by  the  process  of  melting,  the  free  movement  of 
metal  into  coins  and  coins  into  metal  prevents  any  great 
difference  between  the  value  of  the  coin  and  that  of  the 
specific  amount  of  metal  which  it  contains.  If  23.22  grains 
of  pure  gold  become  worth  more  in  the  form  of  a  dollar  than 
they  are  worth  in  the  form  of  raw  gold,  a  stream  of  gold  will 
flow  to  the  mints  until  the  difference  is  wiped  out ;  conversely, 
if  this  amount  of  gold  becomes  worth  more  in  the  form  of 
bullion  than  in  the  form  of  a  dollar,  dollars  will  be  melted 
and  sold  in  the  bullion  market.  The  same  forces  of  supply 
and  demand  operating  in  the  silver  standard  countries  bring 
about  a  fixed  relationship  between  the  values  of  the  standard 
coin  and  the  standard  metal  so  long  as  the  mints  are  open  to 
free  coinage.  When,  however,  the  mints  are  closed  to  the 
free  coinage  of  silver,  and  the  number  of  silver  coins  per- 
mitted in  circulation  is,  by  consequence,  strictly  limited,  the 
value  of  the  standard  coin  will  no  longer  be  subject  to  fluctua- 
tions in  harmony  with  the  value  of  the  metal,  and  the  at- 
tempt to  give  this  standard  coin  a  fixed  par  of  exchange  with 
gold  may  hope  of  success. 

After  the  mints  have  been  closed  in  the  silver  country,  the 
price  of  silver  may  fall  in  the  market  without  depressing  the 
value  of  the  standard  coin.  Coins  will  no  longer  represent 
merely  specific  amounts  of  metal;  they  will  have  a  scarcity 
value  due  to  the  strict  limitation  on  their  manufacture  and 
the  need  of  the  people  for  a  sufficient  quantity  of  money  to 
function  as  a  medium  of  exchange.  If  the  trend  of  the  price 
of  silver  is  upward,  however,  a  point  may  be  reached  at 
which  it  becomes  profitable  to  melt  the  coins  and  sell  them 
as  bullion;  but  this  event  can  be  forestalled  by  the  Govern- 
ment by  lightening  the  weight  of  the  silver  coins  as  occasion 
may  arise.  It  is  also  the  practice  to  guard  against  this  con- 
tingency by  overvaluing  the  silver  coin  at  the  outset  —  that 
is,  by  so  limiting  the  amount  in  circulation  as  to  give  the  coin 
an  initial  value  in  excess  of  its  metal  content.  Having 
adopted  these  measures,  the  Government  proceeds  to  place 


74  FOREIGN  EXCHANGE 

a  dofiiiito  ftold  price  upon  the  silver  money  by  undertaking  to 
exchange  this  money  for  gold  at  the  treasury  upon  staled 
terms. 

At  this  point  it  may  be  said  that  a  fixed  par  of  exchange 
has  been  created  between  the  standard  silver  coin  and  the 
gold  money  of  other  nations.  But  something  must  yet  be 
done  to  prevent  the  market  rates  of  exchange  from  deviating 
too  widely  from  this  par.  Between  two  gold  standard  or  two 
silver  standard  countries,  as  we  have  seen,  this  restraining 
influence  upon  the  rates  of  exchange  is  exerted  by  the  ship- 
ment of  specie  whose  effect  is  to  set  rather  rigid  minima  and 
maxima  to  the  range  of  fluctuation  of  the  market  rates  of  ex- 
change. But  when,  by  the  methods  just  described,  a  silver 
country  has  given  its  standard  coin  an  artificial  value  di- 
vorced from  the  value  of  its  metal  content,  the  specie  points 
will  function  in  one  direction  only;  in  the  silver  country  the 
rates  of  exchange  on  bills  drawn  in  gold  will  have  a  specie 
importing  point »  but  no  specie  exporting  point,  while  in  gold 
countries  the  rates  on  bills  drawn  in  the  silver  money  will 
have  a  specie  exporting,  but  no  specie  importing  point. 
Hence,  the  gold  rates  in  the  silver  country,  although  they 
cannot  fall  below  a  certain  point,  may  rise  indefinitely;  and, 
conversely,  the  silver  rates  in  the  gold  country,  although  they 
cannot  rise  above  a  certain  point,  may  fall  indefinitely.  This 
is  true  because  specie  will  move  in  one  direction  only  be- 
tween the  two  countries,  namely,  from  the  gold  country  to 
the  silver;  the  silver  coins,  having  an  artificial  value,  are  not 
exportable,  whereas  the  ofl"er  of  the  Government  of  the  silver 
country  to  exchange  these  coins  for  gold  upon  fixed  terms 
gives  the  gold  coins  of  other  countries  an  export  value. 

The  final  step  in  the  process  of  stabilizing  the  terms  of  ex- 
change between  the  silver  coin  and  the  gold  coin  of  other 
countries  is  to  supply  this  lack  of  a  specie  exporting  point  in 
the  silver  country.  This  the  Government  does  by  under- 
taking to  sell  an  unlimited  amount  of  exchange  payable  in 
some  gold  standard  country  at  fixed  rates  which  stand  as 
nearly  as  possible  at  the  exporting  point;  while,  at  the  same 
time,  an  agent  oi  the  Government  in  the  gold  comitry  offers 


RATES  OF  EXCHANGE  75 

bills  payable  in  the  silver  coin  at  rates  approximating  the 
specie  exporting  point  there.  Business  men  in  the  two  mar- 
kets will,  of  course,  not  avail  themselves  of  these  offers  of  ex- 
change so  long  as  they  can  buy  the  bills  they  need  at  cheaper 
rates;  but  when  the  rates  rise  to  the  specie  points  in  these 
respective  markets,  the  Government  bills  will  be  bought  and 
a  further  rise  of  the  rates  prevented.  It  is  not  the  practice 
to  stabilize  the  rates  with  respect  to  more  than  one  gold  stand- 
ard country,  but  this  is  sufficient  to  give  the  silver  money  a 
stable  value  in  terms  of  other  gold  coins,  as  well;  for,  as  we 
have  seen,  the  standard  gold  coins  of  all  nations  have  fixed 
pars  of  exchange  with  each  other,  and  any  silver  coin  ex- 
changing on  fixed  terms  with  one  of  them  will  have  a  fixed  par 
with  the  others.  In  summary  of  the  preceding  explanation 
we  may  say  that  the  gold  exchange  standard  has  these  es- 
sentials: (a)  there  must  be  no  free  coinage  of  the  standard 
silver  coin;  (6)  this  silver  coin  must  be  given  a  fixed  value  in 
gold;  (c)  the  exchange  rates  between  the  silver  country  and 
gold  countries  must  be  confined  within  the  specie  points  by 
reason  of  the  Government's  offer  to  supply  gold  bills  of  ex- 
change in  the  silver  country  at  certain  maximum  rates,  and 
silver  bills  of  exchange  in  the  gold  country  at  certain  maxi- 
mum rates. 

Illustration  of  these  principles  may  be  taken  from  the  ex- 
perience of  the  Philippine  Islands.  In  1903,  the  mints  were 
closed  to  the  coinage  of  the  silver  peso  and  this  coin  wag  given 
an  inflated  value  of  fifty  cents  in  gold.  The  Insular  Treasury 
then  undertook  to  sell  for  pesos  drafts  payable  in  gold  in  New 
York  from  a  special  fund  provided  in  that  city  for  the  purpose. 
The  rates  charged  for  these  bills  were  fixed  at  a  premium  of 
1  per  cent  for  demand  drafts  and  11/8  per  cent  for  cables, 
these  rates  being  set  as  nearly  as  possible  at  the  specie  ex- 
porting point  on  dollar  exchange  in  Manila.  In  like  manner, 
the  Custodian  of  the  Gold  Standard  Fund  in  New  York 
offered  for  sale  drafts  payal)le  in  pesos  in  Manila,  charging  a 
premium  of  3/4  per  cent  for  cables  and  3/8  per  cent  for  de- 
mand drafts;  these  rates  were  also  fixed  approximately  at  the 
specie  exporting  point  in  New  York  on  Manila  exchange. 


76  FOREIGN  EXCILVNGE 

The  money  received  in  Manila  in  exchange  for  New  York 
drafts  is  withdrawn  from  circuhition,  to  be  paid  out  only  in 
redemption  of  ^Manila  drafts  sold  by  the  Custodian  of  the 
Fund  in  New  York.  Thus,  when  exchange  on  New  York  had 
risen  to  the  si)e('ie  exporting  point  in  the  Philippines,  the 
Treasury  supplied  the  Philippine  merchant  with  gold  in  New 
York  by  selling  him  a  draft  payable  in  dollars,  and  Mithdrew 
from  circulation  in  the  Islands  an  equivalent  amount  of 
specie.  When,  in  New  York,  the  exchange  rates  on  Manila 
rose  to  the  currency  exporting  point  (United  States  paper 
notes  have  currency  in  the  Philippine  Islands),  the  agent 
of  the  Philippine  Government  supplied  drafts  payable  in 
pesos  in  exchange  for  dollars.  These  drafts,  when  encashed 
in  Manila,  place  a  corresponding  amount  of  money  in  circu- 
lation there. 

By  somewhat  similar  methods,  the  Indian  Government 
stalnlizcd  the  rates  of  exchange  between  the  rupee  and  the 
pound  sterling.  In  1893,  the  mints  were  closed  to  the  free 
coinage  of  the  rupee  and  the  value  of  the  rupee  was  raised 
by  the  Indian  Government  to  IQd.  or  Rs.  15  to  the  pound, 
provision  being  made  for  the  issue  of  silver  rupees  at  this  rate 
in  exchange  for  gold.  In  London,  the  Bank  of  England 
offered,  weekly,  a  certain  amount  of  bills  payable  in  Calcutta, 
Bombay,  and  Madras  in  rupees,  which  were  sold  to  the 
highest  bidder;  the  rate  bid  for  these  drafts  did  not,  of  course, 
rise  above  the  specie  exporting  point,  since  British  merchants 
had  the  option  of  shipping  gold  to  India  and  exchanging  it  for 
the  rupee  at  the  rate  of  Rs.l5  to  the  pound  sterling.  In  nor- 
mal times  the  demand  in  India  for  sterling  drafts  rarely  ex- 
ceeded the  supply  sufficiently  to  drive  the  sterling  rates  to  the 
export  point,  but  on  two  occasions  when  this  occurred,  the 
Indian  Government  came  into  the  market  as  seller  of  sterling 
bills  at  a  rate  approximating  the  specie  exporting,  thus 
stopping  the  rise  of  the  rates. 

The  gold  exchange  standard  has  also  been  introduced  into 
the  Straits  Settlements.  The  silver  dollar  in  circulation  there 
was  given  a  value  of  28(/.  in  gold;  the  Singapore  Government 
undertook  to  sell  cable  transfers  on  London  at  the  rate  of 


RATES  OF  EXCHANGE  77 

27  ll/lGd.  per  dollar  (a  premium  of  5/l6d.,  which  was  ap- 
proximately the  specie  exporting  point  on  sterling  exchange 
in  Singapore) ;  while  London  sold  cable  exchange  on  Singapore 
at  28  3/Wd.  (a  premium  of  3/Wd.,  again  approximately  the 
specie  point).  Many  years  of  successful  operation  of  the 
gold  exchange  standard  in  these  countries  has  demonstrated 
its  effectiveness  in  giving  silver  coins  a  fixed  par  with  gold 
coins  and  confining  the  fluctuations  of  the  rates  within  the 
limits  of  the  specie  points.* 

20.  Causes  of  abnormal  fluctuations  in  the  rates  of  ex- 
change. Under  certain  abnormal  conditions,  the  rates  of 
exchange  will  break  through  the  specie  points  and  stand  for 
short  periods  of  time  at  excessive  discounts  or  premiums. 
One  of  the  most  powerful  of  causes  producing  such  a  situation 
is  a  crisis  in  the  political  or  economic  affairs  of  the  nations 
concerned.  If,  for  example,  there  were  rumors  in  New  York 
of  an  impending  financial  panic  in  London,  every  banker  or 
merchant  in  New  York  who  had  payments  due  him  from 
England  would  be  in  an  inordinate  hurry  to  turn  his  credit 
into  dollars.  Thus  a  sudden  supply  of  sterling  bills  would  be 
thrown  on  the  market  and  the  exchange  rates  would  break. 
The  discount  might  not  stop  at  the  specie  import  point,  since 
fear  that  gold  would  be  unobtainable  in  London  might  re- 
strain the  bankers  from  buying  sterling  drafts  even  at  rates 
low  enough  to  cover  the  costs  of  importing  specie.  Moreover, 
even  if  the  bankers  were  confident  of  their  ability  to  turn 
every  draft  into  gold  in  London,  the  flood  of  bills,  and  the 
insistence  of  the  sellers  upon  immediate  payment,  might  be 
so  great  as  to  deny  the  bankers  sufficient  time  to  bring  the 
gold  to  New  York  in  large  enough  quantity  to  keep  them- 
selves in  funds  for  the  purchase  of  bills. 

Under  panic  conditions,  time  becomes  a  vital  factor,  and, 
despite  the  marvelous  perfection  of  the  mechanism  for  mak- 

^  The  breakdown  of  the  gold  exchange  standard  in  all  the  countries  men- 
tioned under  the  stress  of  the  widely  fluctuating  prices  of  silver  during  the 
war  had  not  been  repaired  at  the  time  of  writing.  It  is  probable  that  the 
standard  will  l)e  retained  when  conditions  arc  again  normal,  though  the  evalu- 
ation of  the  different  silver  coins  in  terms  of  gold  may  be  adjusted  to  changed 
conditions. 


78  FOREIGN  EXCHANGE 

injT  pnymcnts  bet  ween  nations,  the  shipment  of  f»oM  is  still  a 
tinio-consuniing  process.  When  business  confidence  is  break- 
ing down,  even  the  few  days  which  must  elapse  between 
the  purchase  of  sterling  bills  in  New  York  and  the  receipt  of 
gold  from  London  may  be  sufficient  to  keep  the  demand  of 
the  bankers  lagging  behind  the  supply  of  bills.  Furthermore^ 
in  times  of  crisis,  the  risk  involved  in  the  purchase  of  foreign 
bills  of  exchange  is  abnormally  large;  the  foreign  drawee  may 
refuse  to  accept  the  draft,  or  may  be  insolvent  when  it  ma- 
tures. This  uncertainty  as  to  the  security  of  the  bills  of  ex- 
change still  further  retards  the  demand  of  bankers  during 
periods  of  crisis. 

For  these  reasons,  the  exchange  rates  are  a  sensitive  ba- 
rometer of  the  state  of  international  business  confidence.  The 
rates  which  rule  the  market  result  from  the  reflection  of  the 
keenest  and  best-informed  minds  in  the  business  world  upon 
the  economic  condition  of  all  the  nations.  So  exactly  do 
these  rates  record  the  favorable  and  unfavorable  elements 
in  the  economic  life  of  any  country  that  the  trained  observer 
can,  from  their  course,  interpret  with  considerable  accuracy 
the  economic  health  of  the  market  on  which  they  are  drawn. 
There  is  no  better  indication  that  the  business  structure  of  a 
nation  is  considered  unstable  than  the  appearance  of  abnor- 
mal discounts  against  her  in  the  exchange  markets  of  other 
nations.  Each  crisis  and  financial  panic  through  which  the 
United  States  has  passed  in  recent  decades  has  seen  American 
exchange  quoted  at  excessive  discounts  in  London  and  other 
financial  centers. 

Of  similar  effect  upon  the  rates  of  exchange  is  the  danger  of 
war,  revolution,  or  other  political  disturbance.  Such  crises 
in  the  political  life  of  nations  work  havoc  among  the  business 
men,  undermining  credit  and  often  causing  wholesale  insol- 
vency. Forecasting  an  event  of  such  magnitude,  the  traders 
in  the  exchange  drawn  upon  the  nation  affected  will  react  in 
the  same  manner  as  if  this  nation  were  threatened  with  com- 
mercial crisis;  every  one  will  be  reluctant  to  pay  out  money 
to  acquire  credit  instruments  drawn  upon  banks  or  business 
men  in  the  troubled  area,  while  those  who  have  such  instru- 


RATES  OF  EXCHANGE  79 

ments  for  sale  will  be  anxious  to  turn  them  into  cash. 
Since  no  one  can  be  assured  that  the  political  upheaval  wall 
not  prevent  the  withdrawal  of  gold  from  the  foreign  market, 
the  specie  importing  point  will  temporarily  be  ineffective  in 
arresting  the  decline  of  the  exchanges.  For  these  reasons,  the 
varying  fortunes  of  a  nation  at  war  will  be  registered  in  the 
rates  at  which  her  bills  are  quoted  in  the  markets  of  other 
nations;  alternating  victory  and  defeat  will  quickly  be  re- 
flected by  the  rise  and  fall  of  these  rates. 

Of  course,  the  specie  points  cease  to  limit  the  rise  or  fall  of 
the  exchange  rates  when  restriction  or  prohibition  is  placed 
upon  the  movement  of  gold  between  nations.  If  the  re- 
striction take  the  form  of  a  tax  or  a  premium  charged  upon 
the  gold  when  it  is  obtained  for  exportation,  the  effect  will  be 
simply  to  establish  a  new  specie  point  which  includes  the  new 
cost,  and  this  new  point  will  be  as  effective  as  the  old  one  so 
long  as  the  conditions  remain  unchanged.  For  example,  if  a 
tax  of  ten  per  cent  must  be  paid  to  obtain  gold  in  London, 
this  new  charge  will  be  added  to  the  other  costs  of  importing 
specie  and  the  effect  will  be  to  remove  the  specie  importing 
point  to  a  lower  quotation  and  so  permit  a  greater  discount 
on  sterling  bills.  It  must  not  be  assumed,  however,  that  the 
tax  on  gold  will  of  itself  produce  a  discount  on  sterling  ex- 
change in  the  markets  of  other  countries.  If  a  discount 
appears,  it  will  be  because  the  supply  of  sterling  bills  over- 
balances the  demand  for  them,  and  the  influence  of  the  tax 
on  gold  will  be  confined  to  permitting  any  discount  which  does 
appear  to  reach  a  lower  point  before  it  is  checked  by  the  im- 
portation of  specie. 

When  nations  prohibit  the  exportation  of  gold,  or  refuse  to 
surrender  it  in  exchange  for  checks  or  paper  money  at  the  cen- 
tral banks,  the  specie  importing  point  will  no  longer  affect  the 
rates  at  which  bills  drawn  on  such  nations  are  sold  in  foreign 
markets.  Since  the  Great  War,  the  belligerent  nations  of 
Europe  have  been  so  drained  of  gold  that  no  more  is  obtain- 
able at  their  central  banks,  and  the  supply  in  the  market  is  so 
meager  that  it  is  impossible  to  foretell  from  day  to  day  what 
premium  gold  will  command  in  terms  of  the  paper  money  of 


80  FOREIGN  EXCHANGE 

tlicsc  nations.  The  host  view  to  take  of  the  exchanges  under 
these  conditions  is  tliat  the  nations  in  question  are  no  longer 
gold  stjindard  nations  and  tliat  the  pars  of  exchange  must  1-e 
calcuhitcd  anew  by  one  of  the  two  methods  discussed  earher 
in  this  chapter.  While  the  old  gold  pars  of  exchange  are  in 
abeyance,  the  specie  importing  and  exporting  points  have,  of 
course,  no  corrective  influence  upon  the  fluctuations  of  the 
rates;  or,  to  state  the  matter  with  greater  accuracy,  the  old 
specie  points  have  lost  their  significance  and  new  ones  must  be 
derived  to  conform  to  the  new  pars  of  exchange  based  on  the 
premium  on  gold  in  the  paper  standard  countries.  A  striking 
illustration  of  the  effect  of  a  removal  of  the  specie  points  upon 
the  rates  of  exchange  is  to  be  found  in  the  quotations  on  bills 
drawn  upon  Buenos  Aires  during  the  month  of  July,  lOSO. 
The  sup])ly  of  Argentine  bills  in  the  New  York  market  began 
to  outstrip  the  demand  of  our  importers  and,  consequently, 
the  quotations  moved  to  a  discount.  This  discount  was 
temporarily  stopped  at  the  specie  point  as  gold  began  to 
move  into  New  York,  until  the  Argentine  Government  for- 
bade further  exportation  of  gold,  when  the  lower  limit  was 
suddenly  removed  and  the  quotation  fell  to  an  abnormally 
low  point. 

21.  Relation  of  the  exchange  bankers  to  the  rates  of  ex- 
change. It  is  commonly  believed  that  the  dealers  in  the  ex- 
change market  fix  the  rates  at  which  the  different  bills  are 
bought  and  sold.  Our  discussion,  however,  has  shown  that 
what  these  dealers  do  in  reality  is  to  offer  to  buy  or  sell  bills 
of  exchange  at  rates  which  reflect  the  desirability  to  them  of 
funds  in  the  foreign  cities  where  the  bills  are  payable.  The 
desirability  of  these  funds,  it  may  be  repeated,  is  a  function 
of  their  amount  in  relation  to  the  use  which  can  be  made  of 
them;  their  amount  is  determined  by  the  supply  of  bills 
offered  to  the  dealers  by  their  clients  in  the  business  world, 
and  their  use,  by  the  demand  of  other  business  men  for  the 
drafts  which  the  dealers  are  able  to  draw  against  the  foreign 
funds.  Thus  the  rates  are  controlled  fundamentally  by  the 
forces  of  demand  and  supply  of  bills  of  exchange,  fluctuating 
under  normal  conditions  within  the  narrow  range  fixed  above 


RATES  OF  EXCHANGE  81 

and  below  par  by  the  costs  of  exporting  and  importing  specie. 
Of  these  forces  of  demand  and  supply,  some  operate  with 
relative  constancy  and  uniformity,  and  are,  therefore,  sus- 
ceptible of  prediction;  while  others  vary  abruptly  and  cause 
sudden  fluctuations  in  the  rates  of  exchange.  It  is,  for  ex- 
ample, possible  to  foretell  with  some  degree  of  accuracy  not 
only  what  amount  of  bills  will  be  drawn  against  our  ship- 
ments of  cotton,  but  also  at  what  season  of  the  year  these 
bills  may  be  expected  to  appear  on  the  market.  So  also  with 
the  seasonal  demand  for  exchange  with  which  to  cover  the 
expenditures  of  American  tourists  in  Europe,  and  other 
particular  sources  of  demand  which  go  to  make  up  the  total 
demand  of  the  New  York  market.  Underlying  all  other 
forces  and  dominating  the  rates  of  exchange  over  long-run 
periods,  is  the  foreign  trade  of  the  nation;  about  these  basic 
causes  play  the  more  occasional  and  erratic  forces  which 
produce  a  supply  of  bills  or  cause  a  demand  for  them,  and  so 
cause  the  daily  fluctuations  of  the  rates  which  depart  from 
the  expected  trend. 

It  is  the  business  of  the  exchange  dealer  so  to  multiply  and 
perfect  his  means  of  gathering  information  regarding  the 
sources  of  supply  and  demand  as  to  be  able  to  predict  what 
the  behavior  of  the  rates  will  be.  Only  slightly  and  tem- 
porarily, by  processes  which  we  shall  examine  in  the  following 
chapter,  can  the  dealers  in  exchange  influence  the  rates,  and 
then  chiefly  by  cooperating  with  the  forces  of  demand  and 
supply  which  are  their  final  causes.  In  the  main,  all  they 
can  do  is  to  determine  with  all  possible  exactness  what  quo- 
tations will  result  from  the  interplay  of  the  forces  which  arise 
from  the  business  world  about  them,  and  govern  their  own 
terms  of  purchase  and  sale  accordingly.  Thus,  with  sterling 
rates  at  par,  if  the  bankers  have  reason  to  expect  the  forth- 
coming supply  of  sterling  bills  to  be  so  large  as  unduly  to  ex- 
pand their  London  balances,  they  will  set  the  rate  on  their 
demand  drafts  somewhat  below  par.  If  their  prediction 
proves  to  be  wrong,  the  unexpected  demand  will  soon  cause 
them  to  raise  their  rates  until  a  point  is  reached  at  which 
equilibrium  results  between  their  purchases  and  sales;  that 


82  FOREIGN  EXCHANGE 

is  to  say,  a  point  at  which  they  are  able  to  replenish  their 
London  balances  by  the  purchase  of  sterling  bills,  and  reduce 
them  by  the  sale  of  demand  drafts  in  substantially  equal 
amounts.  These  tentative  bids  and  offers  of  the  exchange 
bankers  are  approximations  to  the  ideal  rates  at  which  de- 
mand and  supply  will  be  in  equilibrium. 


CHAPTER  IV 

INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE 

22.  The  schedule  of  rates  in  the  same  market.  Bills  of  ex- 
change are  instruments  and  aids  of  commerce,  drawn  not  to 
conform  to  a  set  pattern,  but  to  meet  the  needs  of  commercial 
transactions,  and  deriving  their  character  in  each  particular 
instance  from  the  terms  of  the  transaction  out  of  which  they 
arise.  When  brought  into  the  exchange  market  for  sale,  they 
disclose  both  similarities  and  differences;  similarities  due  to 
certain  basic  likenesses  which  characterize  all  international 
trading;  differences  due  to  the  diverse  character  of  their 
parties  and  of  the  terms  of  the  transaction  which  have  re- 
sulted from  bargain  between  them.  The  practice  of  the  ex- 
change market  in  quoting  rates  upon  these  different  classes 
of  bills  takes  account  of  both  the  uniformities  and  the  differ- 
ences; a  few  main  groups  are  made,  each  of  which  commands 
a  specific  rate  of  exchange,  a  rate  which  may  be  called  the 
normal  buying  price  for  bills  within  that  group.  Account  is 
then  taken  of  the  individual  differences  between  the  bills  of 
exchange  thus  classified  together,  and  the  normal  rate  is  ad- 
justed by  bargain  between  the  banker  and  his  client  when 
the  negotiation  of  the  bill  is  consummated.  The  normal 
rates,  therefore,  form  a  series  or  schedule  which  lays  down 
the  general  terms  upon  which  the  dealers  in  the  market  are 
prepared  to  buy  certain  kinds  of  bills;  the  rates  which  com- 
pose this  series  are  the  following: 

(1)  The  rate  for  telegraphic  transfers  or  cables. 

(2)  The  rate  for  bankers'  demand  drafts  or  checks;  called 
the  "sight"  rate. 

(3)  The  rate  for  bankers'  long  bills  (sixty  or  ninety  days). 

(4)  The  rate  for  commercial  long  bills. 

The  basis  of  the  schedule  in  any  market  is  the  rate  for 


84  FOREIGN  EXCHANGE 

l);uikrrs'  doniaiu!  dnifts, '  or  the  s^ight  rate,  as  it  is  called,  for 
ui)oii  this  rate,  by  processes  discussed  in  the  preceding  chapter, 
are  focused  the  forces  of  supply  and  demand  in  the  market  at 
large.  The  other  quotations  in  the  schedule  are  derived  from 
this  standard  rate  and  connected  with  it  in  more  or  less  rigid 
union,  the  "spread"  between  the  sight  rate  and  the  rates  for 
other  classes  of  bills  being  determined  by  the  differences  in 
security  and  term  of  life  which  distinguish  these  bills  from 
bankers'  demand  drafts. 

23.  The  cable  rate.  Cables,  alone,  command  a  rate  of  ex- 
change higher  than  the  sight  rate.  Drawn  by  bankers  upon 
foreign  banks,  cables  are  identical  in  security  with  bankers* 
demand  drafts,  differing  from  the  latter  only  in  the  time 
element  involved  in  their  use.  To  make  clear  why  this 
difference  causes  a  spread  between  the  rates  for  checks  and 
cables,  it  is  necessary  first  to  explain  how  the  time  element  in 
bills  of  exchange  affects  the  costs  of  bankers  who  sell  them; 
for  only  w^hen  the  time  element  is  drawn  into  the  banker's 
calculations  as  one  of  the  costs  involved  in  the  sale  of  a  bill  of 
exchange  does  it  influence  the  rates  of  the  exchange  market. 
If,  in  order  to  place  himself  in  position  to  sell  a  particular 
kind  of  exchange,  the  banker  must  first  make  an  advance 
of  funds  over  a  certain  number  of  days,  his  loss  of  interest 
must  be  reckoned  among  the  costs  of  supplying  the  bill. 
Drafts  sold  by  bankers  in  the  market  are  drawn  against 
foreign  balances  placed  to  the  bankers'  credit  in  the  cities 
where  the  drafts  are  payable.  When,  to  place  these  balances 
in  the  foreign  city  in  time  for  the  redemption  of  the  draft,  it 
is  necessary  to  expend  money  some  days  in  advance  of  draw- 
ing, interest  will  be  lost  during  the  interval  of  time  between 
the  banker's  expenditure  and  the  return  of  his  funds  through 
the  sale  of  the  draft.     In  order  to  assure  himself  a  profit  from 

^  The  rate  for  bankers'  bills  is  not  always  uniform,  since  there  are  slight 
differences  in  the  credit  rating  of  different  bankers.  The  basic  rate  of  the 
market  is  the  rate  for  the  sight  drafts  of  prime  bankers;  that  is,  bankers  of 
the  highest  standing.  The  element  of  risk  in  these  prime  bills  is  near  the 
vanishing  point.  The  difference  between  the  rates  applying  to  the  bills  of 
different  bankers  is,  therefore,  almost  negligible.  These  remarks  apply,  also, 
to  the  rates  on  bankers'  long  bills  discussed  below. 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    85 

the  sale,  the  rate  at  which  the  draft  is  priced  must  be  high 
enough  to  return  this  interest  along  with  the  other  costs.  In 
the  case  of  demand  drafts,  no  interest  cost  need  be  included 
by  the  banker  in  his  determination  of  the  rate  of  exchange, 
since  the  cover  for  the  draft  may  be  bought  upon  the  very  day 
when  the  sale  occurs.  Both  demand  draft  and  cover  will  go 
forward  by  the  same  steamer,  with  the  result  that  the  foreign 
correspondent  is  placed  in  funds  in  time  to  redeem  the 
banker's  draft. 

To  illustrate  this  point,  let  us  assume  that  a  New  York 
banker  has  sold  a  sterling  demand  draft  for  one  thousand 
pounds  drawn  on  a  London  correspondent.  The  buyer  has 
procured  this  instrument  to  meet  some  particular  need  of  his 
business,  very  probably  the  necessity  of  remitting  payment  to 
some  English  exporter.  Six  or  seven  days  will  pass  before 
the  demand  draft  will  arrive  in  England;  some  hours,  perhaps 
a  whole  day,  in  addition,  before  the  payee  will  present  it  to 
the  London  correspondent  for  redemption.  Clearly,  if  the 
New  York  banker  buys  a  sterling  bill  which  will  be  worth  one 
thousand  pounds  sterling  upon  its  arrival  in  England  and  sends 
it  directly  to  the  correspondent  by  the  same  steamer  which 
carries  his  own  sterling  demand  draft,  the  London  banker 
will  have  funds  in  hand  when  presentment  is  made.  On  this 
side,  the  banker's  purchase  and  sale  may  occur  on  the  same 
day,  so  that  no  significant  loss  of  interest  need  be  involved 
in  his  purchase  of  cover  for  the  draft  upon  his  foreign  balance. 
It  is  not  the  intention  of  this  illustration  to  lay  down  the 
strict  rule  that  exchange  bankers  go  into  the  market  and  buy 
cover  for  each  individual  sight  draft  which  they  sell.  None 
the  less,  this,  in  effect,  is  what  they  do;  for  the  principle  upon 
which  they  conduct  their  business  in  bills  of  exchange  is  one 
of  compensating  purchase  and  sale  —  the  purchase  of  cover 
and  the  sale  of  drafts  in  substantially  equal  amounts  from 
day  to  day  —  so  that  the  two  may  offset  each  other  without 
causing  an  interest  loss.  Hence,  as  a  rule,  the  selling  price 
for  a  demand  draft  docs  not  include  an  interest  charge;  the 
banker's  profit  from  this  type  of  business  is  drawn,  not  from 
an  advance  of  funds  on  his  part,  but  from  a  slight  difference 


8G  FOREIGN  EXCHANGE 

ill  his  favor  between  the  rates  at  which  he  buys  cover  and  sells 
(l<>iii;uui  drafts.' 

When  a  cable  is  sold,  however,  a  simultaneous  purchase  of 
cover  is  impossible.  The  telegraph  will  bring  the  draft  to  the 
correspondent  within  a  few  hours  after  its  sale  in  New  York 
and  a  credit  must  have  been  provided  for  it  in  London  some 
time  in  advance.  This  means  that  sterling  bills  must  have 
been  bought  at  least  six  days  before  the  cable  is  sold,  and  that 
the  banker  has  lost  interest  through  this  period  of  time.  The 
higher  rate  which  cables  command  is  to  be  attributed  to  this 
interest  cost  and  not,  as  is  sometimes  assumed,  to  the  extra 
cost  of  using  the  telegraph  service;  this  extra  cost  is  usually 
borne  by  the  buyer  of  the  cable  as  an  additional  and  dis- 
tinguishable charge,  though  when  the  amount  sent  is  sufB- 
ciently  large,  the  cable  charge  may  be  borne  by  the  banker 
out  of  his  profit  in  order  to  attract  the  business.  The  process 
of  handling  cables  is  somewhat  different  from  that  of  other 
forms  of  exchange.  The  buyer  does  not  receive  an  instru- 
ment from  the  banker  to  be  remitted  over  the  telegraph  wire, 
but  merely  leaves  the  required  sum  at  the  bank,  together 
with  written  instructions  containing  the  name  of  the  foreign 
payee.  The  banker  then  undertakes  to  wire  in  code  to  his 
correspondent  an  order  that  the  latter  pay  a  certain  sum  of 
money  to  the  designated  party  out  of  funds  which  the  banker 
has  on  deposit  wath  him.  The  buyer  may  have  informed  his 
creditor  in  advance  of  the  payment;  or  this  detail  may  be  left 
to  the  foreign  correspondent. 

Although  it  is  correct  to  say  that  the  cable  rate  is  always 
higher  than  the  sight  rate,  the  exact  difference  between  them 
does  not  seem  always  to  depend  upon  precise  calculation.  If 
the  banker's  selling  price  for  cables  were  governed  strictly  by 
the  principles  involved  in  the  transaction,  the  spread  be- 
tween the  cable  and  sight  rate  would  be  determined  by  the 
following  computation :  to  the  sight  rate  of  the  day  when  the 
cable  is  sold  would  be  added  interest  upon  the  amount  ex- 
pended some  days  earlier  for  the  bills  which  cover  the  cable 

1  For  exceptions  to  this  practice  of  compensating  purchase  and  sale,  see  the 
footnote  to  page  19. 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    87 

at  the  rate  of  interest  which  obtained  when  the  cover  was 
bought.  In  sterling  exchange,  cover  for  a  cable  sold  to-day 
must  have  been  bought  at  least  six  days  ago;  hence  the  cost 
of  the  cover  cannot  be  computed  from  to-day's  sight  rate,  but 
rather  from  the  rate  which  ruled  the  market  six  days  ago. 
The  money  thus  spent  to  enable  the  banker  to  sell  the  cable 
could  have  been  earning  interest  in  the  meantime;  hence  the 
total  cost  must  include  the  loss  of  interest.  In  illustration 
of  these  principles,  we  may  carry  through  a  typical  calcula- 
tion by  which  the  cable  rate  is  determined.  Suppose  to-day's 
sight  rate  is  4.85;  the  sight  rate  six  days  ago,  4.84,  and  the 
rate  of  interest  4  per  cent  per  annum.  The  calculation  is, 
then,  as  follows: 

To-day's  sight  rate 4.85 

Sight  rate  six  days  ago, 
the  cost  of  cover,  4.84. 

Interest  at  4  per  cent  on  4.84  for  six  days 0032 

Cable  rate 4.8532 

Each  pound  sterling  of  the  cable  draft  must  bear  an  interest 
charge  for  six  days  at  4  per  cent  on  the  cost  of  its  cover,  4.84; 
this  amounts  to  .0032,  which  must  be  added  to  the  present 
sight  rate.  In  the  exchange  market  no  place  is  provided  in 
the  standard  scale  of  rates  for  such  a  quotation  as  4.8532  on 
sterling  exchange;  hence,  under  the  assumed  conditions,  the 
cable  rate  would  probably  be  set  at  the  next  higher  standard 
quotation,  4.855. 

Observation  of  the  spread  between  the  cable  and  the  sight 
rates,  appearing  in  market  quotations,  shows  that  the  prac- 
tice of  the  market  is  not  governed  by  the  fixed  principles  ex- 
plained in  the  preceding  paragraph.  At  times  the  bankers 
have  large  balances  in  foreign  cities  of  which  they  are  eager 
to  avail  themselves  quickly;  accordingly,  they  reduce  the 
spread  between  the  cable  and  the  sight  rates  to  stimulate 
their  sales.  At  other  times,  the  demand  for  cables  is  so  large 
as  to  outstrip  the  cover  provided  l^y  prior  remittance  of  l)ills 
by  the  bankers,  and  then  the  cable  rate  soars  high  above  the 
sight  rate.     The  latter  condition  usually  appears  in  times  of 


88 


FOREIGN  EXCHANGE 


panic  or  financial  uncertainty,  when  business  men  are  insist- 
ent upon  obtaining  a  form  of  remittance  which  will  reduce 
the  loss  of  time  to  a  minimum,  when  the  foreign  beneficiary 
of  the  cable  is  willing  to  bear  the  extra  charge  in  order  to  ob- 
tain his  funds  quickly;  or  when  men  with  free  funds  desire  to 
take  advantage  of  a  temporary  situation  in  a  foreign  money 
center.  The  following  series  of  quotations,  taken  from  a  New 
York  financial  journal  for  June  '26,  19^0,  may  serve  to  illus- 
trate the  normal  spread  between  the  cable  and  the  sight  rate: 

Da£A>~D  AM)  Cable  Rates,  New  York,  JrvE  £6.  19"20 


London 

Paris 

SwitzerJand 
Bdgimn .  . . 
HoPand. . . 
Spain 


Dtmaid  rate 


12.04' 
5.49 
11.47 
35.625 
16.68 
41.50 


CdsUr^ 


12.02 
5.47 
11.45 
35.75 
16.75 
41.70 


z*  per  poond 
2  centimes  per  $ 
2  centimes  per  S 
2  centimes  per  S 

12*;;  per  100  gmldos 
7«  per  100  pesetas 

20<^  per  100  pesos 


24.  The  rate  for  bankers'  long  bills.  The  third  rate  in  the 
schedule  of  the  exchange  market  is  that  quoted  upon  bankers' 
long  bills  of  sixty  or  ninety  days'  sight.  These  bills,  drawn 
by  bankers  upon  their  foreign  correspondents,  bear  as  drawer 
and  drawee  names  of  the  same  credit  rating  as  do  demand 
drafts  and  cables,  and  so  do  not  differ  in  security  enough  to 
affect  to  an  appreciable  extent  the  rates  which  they  com- 
mand. It  is  the  time  element,  together  with  certain  other 
costs  involved  in  the  transaction,  which  determines  the 
spread  between  the  rate  for  bankers'  long  bUls  and  that  for 
demand  drafts. 

The  chief  market  for  bankers'  long  bills  is  found  among 
other  bankers  of  the  drawer's  city  who  buy  them  as  a  comple- 
ment of  transactions  in  foreign  exchange  in  which  they  are  en- 
gaged. The  intention  of  the  buyer  is  to  discount  the  long  bill 
upon  its  arrival  in  the  market  upon  which  it  is  drawn,  in- 
crease the  total  of  his  foreign  credit  by  the  amount  of  the  dis- 
count, and  by  this  means  place  himself  in  position  to  draw  and 


INTERRELATION  OF  THE  RATES  OF  EXCHANGE    89 

sell  demand  drafts  in  his  ovm  market.  Sometimes  the  de- 
mand drafts  have  Vjeen  sold  already,  and  the  long  bill  is 
bought  as  cover;  but  whether  the  transaction  in  demand 
drafts  precedes  or  follows  the  purchase  of  the  long  bill,  the 
significance  of  the  long  bill  to  the  banker  will  be  the  same. 
Consequently,  the  price  which  he  is  willing  to  offer  for  it  will 
be  based  upon  two  considerations:  (a)  the  total  amount  of 
demand  drafts  which  the  possession  of  the  long  bill  will  enable 
him  to  draw;  (h)  the  sight  rate  in  the  market  at  the  time. 

A  banker's  long  bill  vsill  not  create  a  foreign  credit  equal  to 
its  face.  A  reduction  will  be  made  on  two  counts;  in  the  first 
place,  the  bill  will  be  discounted  in  the  foreign  money  market 
after  acceptance;  and,  furthermore,  the  foreign  correspondent 
will  pay  stamp  taxes  when  negotiating  the  bill  and  will  charge 
these  back  to  the  bu%'ing  banker.  The  rate  of  discount  which 
will  be  brought  to  bear  upon  the  bill  when  sold  in  the  money 
market  can  be  determined  by  the  buying  banker  from  the 
pubUshed  rates  of  which  he  will  be  informed  daily  by  his  for- 
eign corresj>ondents.  The  stamp  taxes  are  fixed  by  the  Gov- 
ernment of  the  country  upon  which  the  bill  is  drawn,  and  these 
will  be  known  to  the  banker.  A  subtraction  of  these  two 
charges  from  the  face  of  the  long  bill  will  inform  him  of  the  total 
amount  in  demand  drafts  which  its  possession  will  enable  him 
to  draw.  The  existing  sight  rate  in  his  own  market  wiE  set  the 
price  at  which  these  demand  drafts  may  be  sold.  With  these 
facts  before  him,  he  is  in  position  to  compute  his  buying  price. 
To  illustrate  this  computation,  let  us  assume  that  the  banker's 
long  bill  is  drawn  for  ten  thousand  pounds  sterling:  that  the 
rate  of  discount  on  this  class  of  bills  in  the  London  market 
is  3  per  cent ;  that  the  stamp  tax  is  1  ^0  per  cent ;  and, 
finally,  that  the  sight  rate  in  the  New  York  market  on 
sterling  bills  is  4.85,     The  calculation  falls  into  two  parts: 

London  Credit  cexated  bt  Banker's  Long  Bill 

Face  of  bill £10,000. 

Minus  charges: 

Disc-ount  (63  days  @  S%)  51.78 

Stamp  tax  (1,  i6%  X  10.000)     5. 

Total  subtraction 56.78 

Total  sterling  credit £9,9i3.ii  (£9,943, 4*.,  4d.) 


90  FOREIGN  EXCHANGE 

Value  of  London  Cuedit  in  Dollars 
(deteumined  by  Sight  Rate) 

AnuMint  of  storlin-x  credit. £  9,943.22 

Slight  ratc>  of  day  of  purchase 4.85 

Value  of  demand  drafts  drawn  on  London $48,224.01 

Under  the  conciitions  assumed  as  to  discount  rate,  stamp 
taxes,  and  sight  rate,  the  purchase  of  a  banker's  sterHng  long 
bill  for  ten  thousand  pounds  will  create  a  credit  which  will  sell 
for  $48,2:24.61;  the  value  of  each  pound  of  the  long  bill  will  be 
48,224.61  -^  10,000  =  4.8225.  This  will  be  the  rate  of  ex- 
change offered  by  the  buying  banker. 

Another  method  of  arriving  at  this  quotation  is  frequently 
employed  by  the  bankers,  as  follows: 

Sight  rate  of  the  day  of  purchase $4.85 

Subtract  charges  per  pound 

Discount  (63/365  X  .03  X  4.85) 0251 

Stamp  tax  (1/20  per  cent  X  4.85) . .     .0024 

Total  subtraction .0275 

Buying  rate $4.8225 

This  method  arrives  at  the  same  conclusion,  though  it  con- 
ceals somewhat  the  principles  involved  in  the  calculation, 

25.  Rate  of  exchange  for  commercial  bills.  There  is  no 
single  rate  in  the  exchange  market  applying  to  commercial 
bills  of  all  kinds.  Some  types  of  commercial  bills  cannot  be 
sold  at  all.  They  must  be  placed  in  the  hands  of  the  bankers 
for  collection,  the  drawers  waiting  for  the  proceeds  until  pay- 
ment has  been  made  by  the  foreign  drawee.  At  that  time, 
dollar  drafts  may  be  bought  in  the  foreign  market  for  remit- 
tance to  the  drawer  of  the  commercial  bill,  or  the  drawer's 
banker  may  leave  the  amount  collected  standing  to  his  credit 
abroad  and  turn  over  its  equivalent  to  the  drawer  at  the 
sight  rate  of  exchange.  On  other  types  of  commercial  bills, 
the  bankers  will  advance  a  part  of  the  face,  holding  the  rest 
in  reserve  until  collection  is  made  and  charging  interest  on  the 
amount  advanced.    The  credit  element  inherent  in  all  bills  of 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    91 

exchange  is  most  clearly  evident  in  the  case  of  commercial 
bills;  bills  drawn  by  bankers  upon  other  bankers  are  often 
viewed  as  currency,  rather  than  as  credit  documents,  because 
of  the  implicit  confidence  of  the  business  world  in  bank  credit; 
but  bills  drawn  by  a  merchant  or  other  business  man  as  a 
phase  of  a  commercial  transaction,  when  taken  from  the 
drawer  in  exchange  for  cash,  carry  a  risk  of  loss  which  cannot 
be  disregarded.  When  this  risk  is  so  great  that  the  bankers 
refuse  to  buy  the  bill,  but  will  take  it  only  for  collection  at  the 
drawer's  risk,  it  cannot  be  said  that  the  bill  commands  any 
definite  rate  of  exchange;  it  is  the  custom  of  the  exchange 
market  to  speak  of  these  instruments  as  "collection  bills." 

To  understand  whether  a  particular  type  of  commercial 
bill  will  be  bought  by  the  bankers,  and  what  rate  of  exchange 
it  will  command  if  bought,  it  is  necessary  at  this  point  to 
anticipate  in  summary  form  the  description  of  the  various 
kinds  of  commercial  bills  which  will  be  given  in  later  chapters. 
For  our  present  purpose,  it  suffices  to  divide  all  commercial 
bills  into  two  main  types:  the  bill  drawn  by  a  business  man 
upon  another  business  man;  and  the  bill  drawn  by  a  business 
man  upon  a  banker  who  has  agreed  to  act  as  acceptor  on  be- 
half of  the  second  business  man.  To  the  first  type,  the  name 
trade  acceptance  is  given  because  of  the  mercantile  nature  of 
the  acceptor's  business;  for  a  similar  reason,  the  second  type 
of  commercial  bill  is  given  the  name  bankers'  acceptance.  We 
are  dealing  here  solely  with  long  bills;  and  in  almost  every 
ease,  whether  they  are  trade  acceptances  or  bankers'  accept- 
ances, commercial  long  bills  are  supported  by  collateral  se- 
curity in  the  form  of  documents  —  bill  of  lading,  insurance 
policy,  etc.  —  which  give  the  owner  of  the  bills  control  over 
the  goods  which  have  been  sold.  In  the  case  of  the  first  type 
of  commercial  bill  —  trade  acceptances  —  these  documents 
are  surrendered  to  the  drawee,  either  at  the  time  of  accept- 
ance or  when  payment  is  made.  With  bankers'  acceptancesj 
the  second  type  of  commercial  bill  which  we  are  now  discuss- 
ing, it  is  the  universal  practice  of  the  exchange  market  to  sur- 
render the  documents  at  the  time  of  acceptance.  These  dif- 
ferent characteristics  of  the  commercial  bill  determine  its 


92  FOREIGN  EXCHANGE 

salaMHty  and  its  rate  of  exchange.    We  may  summarize  them 
in  tho  following  form: 

(A)  Trade  acceptances,  drawn  by  one  business  man  upon 
another. 

I:  Documents    against    payment;    called   payment 
hills. 
II:  Documents  against  acceptance:  called  acceptance 
bilb. 

(B)  Bankers'  acceptances,  drawn  by  a  business  man  upon 
a  bank, 

I:  Documents  invariably  against  acceptance. 

In  the  following  discussion,  we  shall  deal  first  with  the 
second  type  of  commercial  bill  —  bankers'  acceptances. 

The  bankers'  acceptance  can  always  be  sold  outright  to  ex- 
change dealers.  This  type  of  commercial  bill  arises  out  of 
business  transactions  between  business  men  of  different  coun- 
tries whenever  the  buyer  has  secured  the  services  of  his 
banker  as  acceptor  of  the  seller's  draft,  and  has  instructed 
the  seller  to  draw  against  the  banker  for  the  value  of  the 
goods.  The  bill  will  be  secured  by  the  documents  mentioned 
above,  and  these  documents  will  be  surrendered  —  thus 
leaving  the  bill  free  from  collateral  security  —  at  the  time  of 
acceptance  by  the  drawee-banker.  The  banker  who  buys 
this  commercial  bill  will  handle  it  in  much  the  same  manner 
as  he  would  a  bankers'  long  bill  of  the  kind  discussed  in  the 
preceding  section;  he  will  forward  it  to  his  foreign  corre- 
spondent, have  it  discounted  in  the  money  market  abroad, 
and  add  the  proceeds  of  the  discount  to  his  foreign  credit. 
His  buying  price  will  be  computed  from  the  same  costs  as  in 
the  case  of  a  bankers'  long  bill,  but  he  will  be  compelled  to 
bear  one  additional  charge  and  this  will  reduce  his  quotation 
a  little  below  the  rate  for  bankers'  long  bills.  This  type  of 
commercial  bill  bears  a  banker's  acceptance  and,  conse- 
quently, commands  the  same  rate  of  discount  as  a  bankers' 
long  bill;  the  stamp  charges  will  also  be  the  same;  but  the 
foreign  correspondent  will  be  compelled  to  handle  the  docu- 
ments which  accompany  the  bill  and  will  charge  an  addi- 
tional commission  for  this  service. 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    93 

To  illustrate  the  buying  price  for  the  commercial  bill 
drawn  upon  a  banker,  we  may  take  the  figures  used  in  the 
preceding  section :  discount  rate,  3  percent;  stamp  tax,  1/20 
per  cent;  sight  rate,  4.85.  The  extra  commission  charge 
varies  in  practice,  but  we  may  assume  a  customary  figure, 
1/32  per  cent.     The  calculation,  then,  proceeds  as  follows: 

Calculation  of  Rate  for  Commercial  Long  Bill  drawn  on 
A  Banker 

Sight  rate  of  the  day  of  purchase 4.85 

Subtract  charges  per  pound  of  bill: 

Discount  (63/365  X  3/100  X  4.85) 0251 

Stamp  tax  (1/20  per  cent  X  4.85) 0024 

Commission  (1/32  per  cent  X  4.85) 0015 

Total  subtraction 029 

Rate  for  the  commercial  bill 4.821 

In  practice  some  allowance  is  made  by  the  buying  banker 
for  the  fact  that  the  credit  rating  of  the  drawer  of  the  com- 
mercial long  bill  is  somewhat  lower  than  that  of  the  drawer  of 
a  bankers'  long  bill.  We  shall  explain  in  a  later  chapter  the 
process  of  negotiating  these  commercial  bills  drawn  on 
bankers.  The  buying  banker  will  demand  proof  that  the 
drawer  is  entitled  to  place  the  foreign  bank  in  the  position  of 
drawee;  when  given  this  proof,  he  will  readily  negotiate  the 
bill,  but  he  cannot  overlook  the  fact  that  its  maker,  being  a 
business  man,  does  not  possess  the  credit  standing  of  a  draw- 
ing banker.  It  is  the  practice  for  the  buying  banker  to  base 
his  purchase  price  upon  the  rate  for  bankers'  long  bills,  allow 
for  the  commission  charge,  and  offer  a  rate  somewhat  lowei 
than  that  resulting  from  the  calculation  given  above.  The 
drawer  of  the  bill  will  obtain  a  number  of  bids  from  com- 
peting buyers  and  sell  at  the  highest  rate  offered. 

The  other  chief  type  of  commercial  long  bill,  the  trade 
acceptance  drawn  by  one  business  man  upon  another,  is  al- 
most invariably  supported  by  collateral  security  in  the  form 
of  shipping  documents.  For  our  present  purpose,  we  have 
divided  these  trade  acceptances  into  two  sub-groups:  the 
'payment  bill  whose  documents  are  surrendered  only  when 


94  FOREIGN  EXCHANGE 

payment  is  made  by  the  accoi)tor;  and  the  acceptance  bill 
wliose  ilociiments  arc  surrentlered  at  the  time  of  acceptance. 
This  distinction  very  materially  ad'ccts  the  salahility  of  the 
bill.  With  regard  to  the  first  of  these  sub-groups,  it  may  be 
said  that  trade  acceptances  whose  documents  are  retained 
until  payment  are  not  usually  purchased  by  the  bankers;  the 
primary  reason  for  this  being  the  fact  that  such  bills  cannot 
be  discounted  in  the  money  market  after  acceptance.  It  is 
the  practice  of  the  exchange  market  to  extend  to  the  drawee 
of  such  a  bill  the  option  of  prepaying  before  maturity,  in  case 
he  wishes,  by  so  doing,  to  gain  possession  of  the  documents 
which  are  attached  to  the  bill.  To  enable  him  to  exercise  this 
option,  the  drawee  must  know  where  his  bill  is  held,  and  the 
necessity  of  keeping  him  informed  on  this  point  obstructs  its 
free  passage  through  the  discount  market.  Furthermore, 
money-lenders  do  not  care  to  invest  in  assets  whose  date  of 
payment  is  indeterminate,  and  so  little  demand  exists  for 
these  "payment"  bills  which  carry  the  option  of  prepay- 
ment at  the  pleasure  of  the  drawee.  Now,  for  a  banker  to 
buy  a  long  bill  which  cannot  be  discounted  necessitates  a 
decision  on  his  part  to  invest  in  the  bill,  since  it  cannot  be 
used  at  the  time  of  acceptance  to  increase  his  foreign  balance, 
and  is,  therefore,  not  available  as  cover  for  sight  drafts.  But 
the  bankers,  like  the  money-lenders  in  the  discount  market, 
do  not  wish  to  hold  assets  whose  maturity  date  is  indeter- 
minate; hence  these  bills  are  not  often  bought  from  the 
drawers,  but  are  taken  only  for  collection.  We  may  say  of 
this  sub-group,  therefore,  that  it  has  no  true  rate  of  exchange. 
The  second  sub-group  of  trade  acceptances  —  those  which 
are  clean  after  acceptance  —  are  not  debarred  from  the  dis- 
count market  and,  consequently,  are  frequently  bought  by 
the  bankers.  But  the  rates  of  discount  at  which  they  are 
sold  in  the  foreign  money  market  vary  in  conformity  with 
the  credit  standing  of  the  acceptor,  and  the  buying  prices 
vary  in  harmony  with  this  factor.  Furthermore,  the  buying 
banker  adjusts  his  price  as  a  measure  of  his  confidence  in  the 
drawer  on  whose  account  he  is  negotiating  the  bill  and  upon 
whom  he  will  rely  to  make  good  any  loss  arising  from  dishonor 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE     95 

by  the  drawee.  Accordingly,  there  is  no  fixed  rate  of  ex- 
change for  bills  of  this  group;  bargain  between  drawer  and 
banker,  in  which  the  latter  gives  full  weight  to  all  credit 
factors  peculiar  to  the  bill  offered  for  sale  —  credit  rating  of 
drawer  and  drawee,  discount  rate  of  the  foreign  money  mar- 
ket, character  of  the  goods  which  serve  as  collateral  security, 
etc.  —  will  result  in  a  quotation.  Only  when  the  standing 
of  the  two  parties  is  of  the  highest  order,  whose  commercial 
paper  commands  a  definite  rate  of  discount  in  the  money 
market,  can  anything  like  a  normal  rate  of  exchange  for  the 
bill  be  said  to  exist.  When  this  is  true,  the  buying  rate  will 
be  calculated  from  the  same  costs  as  those  which  determine 
the  rate  of  exchange  for  bills  drawn  by  business  men  on 
banks;  a  higher  discount  rate  will  be  used  and  the  buying 
price  will  be  proportionately  lower. 

In  summary  of  our  discussion  regarding  the  schedule  of 
rates  upon  different  classes  of  bills,  we  may  gather  together 
in  the  form  of  a  typical  schedule  the  results  of  our  compu- 
tations. 

Schedule  of  Sterling  Rates  m  the  New  York  Market 

Sight  rate  (bankers'  demand  drafts) 4.85 

Cable  rate 4.855 

Rate  for  bankers'  long  bills 4.8225 

Rate  for  commercial  long  bills: 

(a)  Bankers'  acceptances 4.8210 

(6)  Trade  acceptances 

(1)  Payment  bills no  rate 

(2)  Acceptance  bills :  variable  rates,  with  a  normal  the 
same  as  bankers'  acceptances  with  allowance  for 
variation  in  the  rate  of  discount. 

This  interrelation  between  the  rates  for  different  kinds  of 
bills  is  so  close  that  it  is  possible  to  speak  of  a  normal  parity 
between  these  rates.    Taking  bankers'  demand  drafts  as  the 
norm,  the  parity  for  the  other  rates  is  determined  as  follows: 
(A)  Parity  cable:  demand.     The  spread  increases  or  de- 
creases as  the  New  York  interest  rate  increases  or 
decreases;   and  as  the  mailing  time  to  the  foreign 
market  increases  or  decreases. 


06  FOREIGN  EXCHANGE 

(B)  Parifji  hankers'  long:  demand.  Bankers'  long  is  at  par 
with  hankers'  demand  when  its  price  is  equal  to  the 
demand  price  discounted  for  the  period  it  runs  at  the 
arrival  rate  in  the  foreign  market,  with  an  additional 
allowance  for  the  foreign  tax  rate. 

(C)  Parity  commereial  long:  demand.  Commercial  long  is 
at  par  with  bankers'  demand  when  quoted  at  the  same 
rate  as  bankers'  long  minus  allowance  for  the  com- 
mission charges  and  for  the  lower  rating  of  the  drawer. 
If  the  commercial  bill  is  not  marketable,  it  may  be 
said  to  have  no  par  rate. 

As  an  example  of  a  typical  exchange  market  report,  we  take 
the  following  from  the  New  York  Times  for  August  6,  1921 : 

FOREIGN  EXCHANGE 

After  the  brief  activity  of  Thursday,  in  which  sharp  advances 
were  recorded  in  all  principal  exchanges,  the  foreign  exchange  mar- 
ket again  settled  back  into  the  doldrums  yesterday,  and  fluctua- 
tions were  minor  ones,  with  the  market  again  entirely  neglected. 
The  opinion  is  general  that  the  market  was  supported  on  the  previ- 
ous day,  when  a  settlement  of  $5,000,000  was  made  by  Germany 
with  the  Bank  of  England  and  the  Bank  of  France,  in  dollars  de- 
posited in  the  Federal  Reserve  Bank  of  New  York.  At  any  rate, 
there  was  no  pressure  on  either  side  yesterday,  and  at  the  close  of 
the  day  quotations  were  approximately  where  they  had  started. 

Feiday,  August  5,  1921 
Range  of  Rates,  Sight  Exchange  . 


Thursday's 

High 

Low 

Pinal 

Final 

London 

...     $  3.59| 

$  3.59^ 

$  3.59| 

$  3.59| 

Paris 

7.74f 

7.72i 

7.73J 

7.75^ 

Rome 

4.30 

4.29 

4.29^ 

4.33^ 

Amsterdam 

. . .       30.63 

30.55 

30.57 

30.58 

Berlin 

1.24 

1.23i 

1.23i 

1.23| 

Madrid 

. . .       12.89 

12.83 

12.84" 

12.87 

Closing  Rates 

Parity  of  exchange  is  given  as  reported  by  the  U.S.  Mint,  except  in 
countries  with  a  silver  standard,  where  parity  fluctuates  with  the 
price  of  silver. 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    97 


Edbope 

Friday         Week  ago 

Sterling  —  Far  $4.86  5-8  per  sovereign. 
Demand  3.59  3-8         3.55  3-4 

Cables  3.59  7-8         3.50  1-4 

Comm.  60  days         3.56  S.5i  1-4 

Coram.  90  days         3.54  1-2         8.50  3-4 

FranL«  —  Par  19.3  cents  per  franc. 

Demand  7.73  1-4         7.58  1-4 

Cables  7.74  7.59 

Italy  —  Par  19.3  cents  per  lira. 

Demand  4.29  \-Z        4.18  1-2 

Cables  4.30  4.19 

Belgium  —  Par  19.3  cents  per  franc. 
Demand  7.41  7.34 

Cables  7.42  7.35 

Germany  —  Par  23.8  cents  per  mark. 
Demand  1.23  1-2         1.23  3-4 

Cables  1.24  1.24 1-4 

Austria  —  Par  20.3  cents  per  crown. 
Demand  .11  1-4  .12 

Cables  .113-8  .12  1-2 

Czechoslovakia  —  Par  20.3  cents  per  crown. 
Demand  1.27  1.26 

Cables  1.29  1.27 

Denmark  —  Par  26.8  cents  per  krone. 
Demand  15.30  15.12 

Cables  15.35  15.17 

Finland  —  Par  19.3  cents  per  finmark. 
Demand  1.55,  1.57 

Cables  1.58  1.58 

Greece  —  Par  19.3  cents  per  drachma. 
Demand  5.52  5.58 

Cables  5.55  6.61 

Holland  —  Par  40.2  cents  per  florin. 
Demand  30.57  30.73 

Cables  30.59  30.75 

Hungary  —  Par  20.3  cents  per  crown. 
Demand  .26  .27  1-2 

Cables  .26  1-2  .27  3-4 

Jugoslavia  —  Par  20.3  cents  per  crown. 
Demand  .56  3-4  .56  1-4 

Cables  .66  7-8  .56  3-4 

Norway  —  Par  26.8  cents  per  krone. 
Demand  12.75  12.75 

Cables  12.80  12.80 

Poland  —  Par  23.8  cents  per  crown. 
Demand  .05  1-4  .05 

Cables  .05  3-8  .05  1-2 

Rumania  —  Par  19.3  cents  per  leu. 

Demand  1.26  1.2.5  1-4 

Cables  1.28  1.20  1-4 


Edropb 

Friday  Week  ago 

Serbia  —  Belgrade  —  Par  19.3  cents  per  franc 
Demand  2.25  2.25 

Cables  2.26  2.26 

Spain  —  Par  19.3  cents  per  peseta. 
Demand  12.84  12.82 

Cables  12.85  12.83 

Sweden  —  Par  26.8  cents  per  krone. 
Demand  20.45  20.35 

Cables  20.50  20.40 

Switzerland  —  Par  19.3  cents  per  franc. 
Demand  10.58  10.38 

Cables  16.10  18.40 

Far  East 

China —  cents  per  silver  dollar.  Hongkong; 
per  tael  Shanghai  and  Peking. 

Hongkong 

Demand  61.00  60.50 

Cables  61.10  60.60 

Peking 

Demand  74.50  73.50 

Shanghai 

Demand  71.50  70.50 

Cables  72.00  71.00 

India — Calcutta,  cents  per  rupee,  nominally 
stabilized  at  one-tenth  of  a  pound  sterling. 
Demand  23.50  23.125 

Cables  23.75  23.25 

Philippine  Islands  —  Manila:  par  60  cents 
per  silver  peso. 

Demand  48.00  46.50 

Cables  48.25  46.75 

Java  —  Par  40.2  cents  per  florin. 

Demand  32.00  32.00 

Japan  —  Par  49.8  cents  per  yen. 

Demand  48.50  48.125 

Cables  48.76  48.375 

South  America 

Argentina  —  Par  42.44  cents  per  paper  dol- 
lar. 

Demand  28.75  29.125 

Cal)les  28.875  29.25 

Brazil  —  Par  32.45  cents  per  paper  milreis. 
Demand  12.25  11.125 

Cables  12.375  11.25 

Canada 

Montreal  —  Par  100  cents  per  Canadian  dol- 
lar. 
Demand  89.3  88.0 


26.  Arbitrage.  Within  a  given  market,  the  schedule  of 
rates  applying  to  the  different  kinds  of  bills  holds  together  in 
a  fairly  fixed  relationship,  rising  and  falling  in  unison  under 


98  FOREIGN  EXCHANGE 

the  influonce  of  the  forces  of  supply  and  demand  which  play 
ui)on  tiie  rate  for  l)ankers'  deniaiul  drafts  or  checks.  We 
have  now  to  see  that  the  rates  in  difi'erent  markets  at  the 
same  time  are  related  to  each  other;  and,  also,  that  within  the 
same  market  a  relationship  exists  between  the  schedule  of 
rates  at  one  time  and  the  schedule  at  other  times.  That  is  to 
say,  sterling  rates  in  the  New  York  market  on  a  given  date 
and  dollar  rates  in  the  London  market  on  the  same  date  tend 
to  coincide;  also,  sterling  rates  in  the  New  York  market  on 
this  date  will  be  related  to  the  sterling  rates  on  preceding 
dates  and  their  expected  position  on  subsequent  dates. 
These  interrelations  between  the  rates  of  exchange  at  different 
times  and  places  are  brought  about  through  the  forces  of 
arbitrage  and  speculation.  Arbitrage  transactions  of  ex- 
change dealers  bring  the  schedule  of  rates  in  different  markets 
into  harmony  with  each  other  at  a  given  time;  speculation 
brings  into  relationship  the  rates  present,  past,  and  future 
within  a  given  market. 

In  introducing  the  subject  of  arbitrage,  it  is  necessary  at 
the  outset  to  explain  that  arbitrageurs  deal  in  cables  alone, 
so  that  the  effect  of  their  operations  is  exerted  solely  upon  the 
cable  rate.  Furthermore,  it  is  essential  to  see  that  for  each 
quotation  on  sterling  cables  in  New  York  there  is  an  exactly 
equivalent  quotation  on  dollar  cables  in  London,  and  simi- 
larly with  other  foreign  exchanges.  The  effect  of  arbitrage 
transactions  is  to  bring  the  pair  of  quotations  into  equivalence 
with  each  other  when  they  chance  to  diverge  from  their  true 
position.  First  let  us  illustrate  what  is  meant  by  equivalent 
quotations.  Assume  that  sterling  cables  are  quoted  in  New 
York  at  4.85;  the  pound  sterling  contains  240  pence;  if  the 
pound  is  worth  $4.85  in  New  York,  the  dollar  in  London,  to 
be  equivalent  in  value,  should  be  worth  49.48  pence  (240  -h 
4.85).  To  vary  the  illustration,  assume  that  franc  cables  sell 
in  New  York  at  19.5  cents  per  franc;  to  be  equivalent  in 
value,  the  dollar  in  Paris  should,  under  these  conditions,  sell 
for  5.12  francs  (100  h-  19.5).  And  so  for  every  other  possible 
quotation  on  foreign  cables  in  New  York,  however  unusual 
or  abnormal  the  quotation,  there  is  a  rate  in  the  foreign 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    99 

center  which  will  represent  an  equivalent  value  for  the  dollar 
cable.  Arbitrage  transactions  spring  up  when  the  pair  of 
rates  diverge  from  this  position  of  equivalence  and  have  the 
effect  of  bringing  the  two  quotations  into  conformity  with 
each  other. 

The  key  to  the  cause  and  the  effect  of  arbitrage  trans- 
actions lies  in  this  significant  fact:  that  if  the  pair  of  rates 
diverge  from  their  true  position,  the  effect  will  be  either  to 
make  both  appear  cheaper  than  they  should  be,  or  else  to 
make  both  appear  dearer  than  they  should  be.  That  is  to  say, 
if  the  sterling  cable  rate  in  New  York  and  the  dollar  cable 
rate  in  London  lose  their  equivalence,  sterling  cables  will 
either  appear  to  New  York  dealers  to  be  selling  below  their 
true  value  and  dollar  cables  will  at  the  same  time  appear  to 
London  dealers  to  be  selling  below  their  true  value;  or  else, 
the  reverse  will  be  true  in  both  markets  and  the  two  cables 
will  appear  to  be  selling  above  their  true  value.  To  make 
this  clear,  let  us  return  to  the  quotations  assumed  above.  If 
sterling  cables  are  quoted  in  New  York  at  4.85,  dollar  cables 
should  be  quoted  in  London  at  49.48  pence.  Now,  let  these 
quotations  lose  their  equivalence,  the  sterling  rate  in  New 
York  remaining  4.85  and  the  dollar  rate  in  London  falling  to 
49  pence.  Then  look  at  the  situation  through  the  eyes  of  a 
New  York  dealer;  dollars  are  quoted  at  49  pence  in  London; 
hence  sterling  cables  should  be  selling  for  4.89  (240-j-49); 
but  they  are  actually  quoted  at  4.85,  hence  they  appear 
cheaper  than  they  should  be.  Look,  again,  at  the  same 
situation  from  the  viewpoint  of  a  London  dealer;  he  knows 
that  the  sterling  cable  rate  in  New  York  is  4.85  and  that  to  be 
equivalent  the  dollar  cable  rate  in  London  should  be  49.48; 
but  the  dollar  rate  is  actually  49;  hence  dollar  cables  appear 
cheaper  than  they  should  be.  If  the  divergence  had  been  in 
the  opposite  direction,  both  rates  would  have  appeared  too 
high  rather  than  too  low;  but,  for  the  sake  of  simplicity,  we 
may  postpone  a  consideration  of  that  condition  until  we  have 
discussed  the  activities  of  the  dealers  in  the  case  represented 
above;  that  is,  when  in  each  of  the  two  markets  exchange 
drawn  on  the  other  appears  to  be  selling  below  iLs  true  value. 


100  FOREIGN  EXCHANGE 

Arhitrape  transactions  are  carried  on  by  two  men,  each 
located  in  one  of  the  two  markets  concerned,  who  cooperate 
for  mutual  profit.  It  is  their  intention  so  to  conduct  their 
transactions  that  the  operations  carried  on  by  one  will  offset 
those  carried  on  by  the  other.  Thus,  when  the  rates  in  both 
markets  appear  too  low,  both  arbitrageurs  will  buy  cables  to 
remit  to  each  other  for  encashment;  each  will  expend  money 
in  the  purchase  of  exchange,  but  each,  also,  will  receive  from 
the  other  the  cable  transfer  which  the  latter  buys  and  so  have 
in  hand  funds  to  cover  his  expenditure.  Assume,  now,  that 
the  exchange  markets  of  London  and  New  York  are  in  the 
condition  pictured  above:  sterling  cables  in  New  York  quoted 
at  4.85  and  dollars  in  London  at  49  pence;  both,  therefore, 
appearing  cheaper  than  they  should  be.  If  the  arbitrageur 
in  New  York  buys  $10,000  worth  of  sterling  cables  at  4.85, 
he  can  place  in  the  hands  of  his  London  partner  £2061  125.  4(Z. 
If  the  correspondent  in  London  buys  a  $10,000  cable,  it  will 
cost  him  £2041  135.  2d.  Each  will  send  his  cable  transfer  to 
the  other;  the  arbitrageur  in  New  York  will,  accordingly, 
receive  from  London  an  amount  exactly  equal  to  that  he  ex- 
pends on  sterling  cables;  but  the  London  arbitrageur  will 
receive  from  New  York  approximately  £20  more  than  he 
expends.  This  twenty  pounds  is  profit  for  the  two  arbi- 
trageurs. Because  the  two  cable  rates  appeared  low,  both 
arbitrageurs  bought;  hence  they  have  operated  to  raise  the 
rates  and  restore  equivalence  between  them. 

The  divergence  between  the  cable  rates  may  be  such  as  to 
make  both  appear  too  high;  in  this  case  the  arbitrageurs  will 
be  tempted  to  sell  simultaneously,  rather  than  to  buy,  as  in 
the  preceding  example.  For  example,  assume  that  sterling 
cables  in  New  York  are  quoted  at  4.85  and  that  the  dollar 
cable  rate  in  London  has  risen  above  the  point  of  equivalence, 
say  to  50  pence.  From  the  point  of  view  of  a  New  York 
dealer,  sterling  cable  rates  now  appear  higher  than  they 
should  be;  for  with  dollars  quoted  at  50  pence  in  London,  the 
sterling  rate  should  be  4.80,  instead  of  4.85  (240  -^  50).  In 
London,  the  dollar  rate  appears  equally  dear;  for  when  ster- 
ling cables  sell  for  4.85  in  New  York,  dollar  cables  in  London 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    101 

should  sell  for  49.48  pence  and  not  for  50  pence.  Since  the 
two  rates  are  both  higher  than  they  should  be,  both  arbi- 
trageurs are  tempted  to  sell  and  will  do  so,  if  their  trans- 
actions can  be  so  conducted  as  to  offset  each  other. 

This  offset  may  be  brought  about  as  follows:  let  each  arbi- 
trageur sell  a  cable  drawn  on  the  other.  Each  will  then  be  com- 
pelled to  redeem  the  other's  order,  but  will  be  prepared  to  do 
so  out  of  the  funds  raised  through  the  sale  of  his  own  cable. 
Suppose,  then,  that  the  New  York  arbitrageur  draws  and  sells 
a  sterling  cable  for  10,000  pounds  payable  by  his  London 
correspondent;  with  the  rate  at  4.85,  he  will  realize  $48,500 
from  the  sale.  If  the  London  correspondent  draws  a  dollar 
cable  for  this  amount  ($48,500)  on  his  New  York  partner,  he 
can  sell  the  order  for  £10,106.16  (48,500  X  50d.).  In  redeem- 
ing this  cable  drawn  upon  him,  the  New  York  partner  will 
expend  all  that  he  realizes  from  the  sale  of  his  sterling  cable; 
the  London  partner,  on  the  other  hand,  will  be  called  upon  to 
redeem  a  cable  of  £10,000  whereas,  from  the  sale  of  his  dollar 
cable,  he  will  havereahzed  £10,106.16.  Thus  a  profit  of  ap- 
proximately £106  remains  to  be  divided  between  the  two  arbi- 
trageurs. Rarely  do  the  rates  diverge  to  the  extent  assumed 
in  the  preceding  illustrations,  for  arbitrage  transactions  in- 
volving large  sums  spring  up  whenever  the  slightest  dis- 
crepancy appears.  But  these  operations  must  consist  either 
in  buying  when  the  rates  are  below  their  true  position,  or  of 
selling  when  they  are  above  their  true  position;  thus  the 
arbitrageurs  will  force  the  rates  up,  or  down,  until  they  are 
in  equivalence  with  each  other. 

By  an  extension  of  the  arbitrage  process,  the  cable  rates  of 
all  markets  connected  by  unrestricted  communication  will  be 
brought  into  harmony  with  each  other.  Just  as,  between  two 
points,  there  is  a  pair  of  quotations  which  express  exact  equiv- 
alence between  the  cable  rates,  so  among  the  quotations  in 
three,  four,  or  more  markets,  there  is  a  position  of  equivalence 
toward  which  the  rates  tend.  Let  us  suppose,  for  example, 
that  in  New  York  the  sterling  cable  rate  is  4.85  and  the  franc 
cable  rate  fr.  5.18;  under  these  conditions  the  sterhng  cubic 
rale  iu  Paris  ahould  be  fr.  25.12  per  pound.    For  if  each  dollar 


102  FOREIGN  EXCHANGE 

is  worth  .'j.lS  francs  and  the  pound  is  worth  $4,85,  the  price 
of  (he  poiiiul  in  francs,  to  he  in  harmony  with  this  pair  of 
rates,  siiouki  be  fr.  '-25.12  (4.85  X  5.18).  Assume,  now,  that 
the  sterHng  rate  in  Paris  moves  from  this  position  —  say  to 
fr.  25;  arbitrage  transactions  involving  New  York,  London, 
and  Paris  will  iinnicdiatcly  spring  up.  A  New  York  dealer 
with  connections  in  Paris  and  London  may  sell  a  sterling 
cable  for  £10,000  and  realize  $48,500,  covering  the  cable  in 
London  by  buying  another  sterling  cable  for  the  same  amount 
in  Paris  at  a  cost  of  fr.  250,000.  The  cable  sold  in  New  York 
will  be  addressed  to  the  London  correspondent  and  the  one 
bought  in  Paris  will  be  sent  to  this  correspondent  for  encash- 
ment in  time  to  offset  the  order  from  New  York.  Funds 
must  be  placed  in  Paris  to  meet  the  cost  price  of  the  sterling 
cable  bought  there,  and  this  can  be  done  by  remitting  a  franc 
cable  from  New  York  for  the  required  amount  —  fr.  250,000. 
The  buying  of  this  franc  cable  will  cost  $48,324.32,  since  the 
franc  rate  in  New  York  at  this  time  is  5.18.  The  transaction 
wnll  show  a  profit  as  follows:  income  from  sale  of  sterhng 
cable  in  New  York,  $48,500;  cost  of  cover  (francs  bought  in 
New  York,  turned  into  sterling  in  Paris  and  sent  to  London), 
$48,324.32;  profit,  $175.68. 

In  this  illustration,  the  sterling  cable  rate  was  dearer  in 
New  York  and  cheaper  in  Paris;  but  in  putting  through  the 
arbitrage  operation,  the  bankers  will  have  appeared  on  the 
supply  side  of  the  dearer  market  by  offering  sterling  for  sale 
in  New  York,  and  on  the  demand  side  of  the  cheaper  market 
by  buying  sterling  in  Paris.  The  tendency  of  such  trans- 
actions will  be  to  raise  the  cheaper  and  lower  the  dearer  rate, 
thus  bringing  them  into  uniformity  with  each  other.  So 
keen  is  the  watch  kept  by  the  arbitrageurs  on  all  the  markets 
of  the  world  that  discrepancies  of  any  magnitude  rarely 
appear.  Experts  in  arbitrage  operations  will  put  through 
transactions  involving  four  or  more  markets  if  an  opportunity 
for  profit  arises.  Only  in  abnormal  times,  when  communi- 
cation is  broken  or  hampered,  or  when  the  normal  rates  of 
exchange  have  been  abrogated,  do  these  transactions  fail  to 
bring  into  harmony  with  each  other  the  quotations  in  the 
different  markets  at  a  given  time. 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    103 

27.  Speculation  is  buying  at  one  time  and  selling  at  an- 
other. The  sale  may  occur  before  the  purchase,  as  when  the 
speculator  "goes  short"  of  the  article,  by  selhng  at  a  fixed 
price  something  which  he  does  not  possess,  in  the  hope  of 
being  able  to  buy  at  a  profitable  price  before  he  is  obliged  to 
make  delivery.  Or  the  purchase  may  precede  the  sale,  as 
when  the  speculator  buys  an  article  with  the  intention  of 
holding  it  for  resale  at  a  higher  price.  The  economic  effect 
of  speculative  transactions  in  the  exchange  market,  as  in 
other  things,  is  to  produce  a  tendency  toward  uniformity  in 
the  rates  over  periods  of  time  by  increasing  the  demand  when 
bills  are  cheap,  and  the  supply  when  they  are  dear. 

Many  of  the  most  customary  transactions  in  the  exchange 
market  contain  an  element  of  speculation,  though  they  are 
not  carried  on  for  the  primary  purpose  of  gaining  profit  from 
the  speculative  risk.  Whenever  a  banker  buys  a  bill  of  ex- 
change for  investment,  holding  it  until  maturity  instead  of 
discounting  it  after  acceptance,  he  usually  does  so  with  the 
primary  purpose  of  gaining  interest  on  the  money  he  expends. 
But  unless  he  assures  himself  at  the  time  of  buying  the  bill 
of  the  rate  at  which  he  will  be  able  to  draw  his  demand  drafts 
when  the  bill  matures,  his  gains  will  be  affected  by  the  po- 
sition of  the  sight  rate  at  a  future  date.  Again,  when  a 
banker  increases  his  foreign  balance  by  buying  bills  for  dis- 
count at  a  time  when  there  is  little  demand  for  his  sight 
drafts,  he  usually  is  paid  interest  by  the  foreign  correspondent 
on  the  balance,  or  a  portion  of  it.  However,  it  is  not  prob- 
able that  he  would  do  this  for  the  gain  of  interest  alone;  he 
will,  no  doubt,  expect  rising  rates  of  exchange  in  the  future 
and  hope  to  turn  his  foreign  balance  to  good  account  later  on. 
Here  the  motive  is  a  mixture  of  desire  to  take  a  speculative 
risk  and  desire  to  gain  interest.  But  for  the  readiness  of 
bankers  to  buy  bills  when  they  are  plentiful  and  hold  them  to 
maturity,  or  allow  the  credits  which  they  create  to  lie  com- 
paratively idle  abroad,  the  exchange  rates  would  be  subject 
to  much  more  frequent  and  violent  fluctuation. 

On  the  other  hand,  when  the  rates  are  high,  but  seem 
likely  to  fall,  bankers  may  create  a  supply  to  meet  the  oc- 


10  i  FOREIGN  EXCHANGE 

casidn  l>y  borrowing  from  their  forcif»n  correspondents.  The 
loan  takes  the  form  of  a  banker's  lonj^  bill  drawn  ui)on  and 
aeeepted  by  the  foreign  correspondent,  and  sold  in  the  dis- 
count market  abroad  after  acceptance;  the  drawing  of  such 
bills  by  the  bankers  adds  to  the  supply  on  the  market  and 
tends  to  lower  the  rates.  But  the  borrowing  banker  ob- 
ligates himself  to  cover  the  bill  at  maturity  by  placing  sight 
drafts  in  the  hands  of  his  correspondent,  and  this  neces- 
sitates his  buying  in  a  low  market.  In  this  transaction, 
interest  is  gained;  and  again  we  find  a  mixed  motive  actu- 
ating the  bankers.*  Many  other  transactions  are  carried  on 
in  the  exchange  market,  not  for  the  sake  of  the  speculative 
tisk,  or  only  partially  for  the  sake  of  this  risk;  reference  will 
be  made  to  the  speculative  character  of  these  transactions 
at  different  points  in  the  following  chapters. 

However,  the  term  speculation  is  usually  applied  only  to 
those  dealings  in  the  exchange  market  whose  sole,  or  prin- 
cipal, motive  is  the  promise  of  gain  which  the  speculative 
risk  holds  forth.  The  typical  transaction  of  this  kind  in- 
volves the  purchase  or  sale  of  a  future  contract ;  that  is,  a 
contract  which  binds  one  party  to  deliver  a  specified  amount 
of  exchange  to  the  other  at  a  specified  rate  and  upon  a  stated 
date  in  the  future.  Exchange  dealers  who  give  or  take  these 
contracts  conduct  two  kinds  of  operations  in  futures:  those 
which  are  uncovered  at  the  time  the  contract  is  formed;  and 
those  which  are  covered.  An  uncovered  transaction  in 
futures  may  involve  either  the  purchase  or  sale  of  exchange 
by  the  banker.  For  example,  a  merchant  who  will  ship  goods 
at  some  future  date,  and  will  have  bills  for  sale  at  that  time, 
may  wish  to  be  relieved  of  the  risk  of  a  possible  decline  in  the 
rate  of  exchange.  Accordingly,  he  places  with  his  banker 
now  a  promise  to  deliver  a  certain  amount  of  foreign  exchange 
on  the  day  when  shipment  will  be  made,  the  rate  of  exchange 
being  agreed  upon  between  banker  and  merchant  and  written 
into  the  contract.  If  the  banker  elects  to  take  the  risk  of 
being  unable  to  sell  his  own  demand  drafts  at  profitable 
rates  on  the  day  when  the  merchant  will  deliver  the  exchange, 
*  See  discussion  of  finance  bills  in  Chapter  VI. 


INl^RRELATIONS  OF  THE  RATES  OF  EXCHANGE    105 

he  leaves  the  future  uncovered;  that  is,  he  does  not  now  sell 
his  own  contract  to  deliver  the  exchange  to  some  one  else. 
It  is  obvious  that  he  will  run  this  risk  only  if  he  has  reason  to 
believe  that  the  rate  of  exchange  will  rise  in  the  meantime,  thus 
bringing  him  better  terms  for  his  demand  drafts  than  he  could 
get  now  on  his  contract  to  deliver  exchange  at  the  future  date. 

A  sale  of  an  uncovered  future  by  a  banker  is  the  reverse  of 
this  transaction.  The  banker  places  his  promise  to  deliver 
a  certain  amount  of  exchange  at  a  fixed  rate  on  a  stated  future 
day,  trusting  to  be  able  to  buy  the  required  cover  some  time 
before  he  is  called  upon  to  deliver  and  at  a  rate  low  enough  to 
return  a  profit.  The  buyer  of  a  banker's  future  may  be  an- 
other banker  or  a  merchant  who  has  a  remittance  to  make  at 
the  future  date  and  wishes  to  know  in  advance  how  much  the 
remittance  will  cost.  A  banker  will  leave  this  future  un- 
covered only  if  he  is  convinced  that  the  rates  of  exchange  are 
about  to  decline,  just  as  he  will  buy  an  uncovered  future  only 
if  he  believes  the  rates  are  to  rise.  But  operations  of  this  sort 
on  any  considerable  scale  must  necessarily  result  in  diminish- 
ing the  difference  between  the  rates  at  different  times,  since 
they  tend  to  increase  the  supply  of  bills  when  rates  are  high 
and  to  increase  the  demand  for  them  when  rates  are  low. 

The  risk  involved  in  dealing  in  uncovered  futures  is  so  great 
that  bankers  usually  close  out  such  transactions  by  providing 
an  immediate  offset  to  each  transaction.  There  are  different 
ways  of  doing  this,  one  of  which  is  to  bring  the  purchase  and 
sale  of  futures  together  into  one  transaction  so  that  the  one 
future  will  cover  the  other.  For  example,  upon  buying  the 
merchant's  future  in  the  preceding  illustration,  the  banker 
may  immediately  sell  his  own  contract  to  deliver  a  like 
amount  of  exchange  at  the  same  future  date.  If  he  can  get 
a  little  better  price  for  his  own  bills  than  he  gives  for  the  mer- 
chant's, the  banker  will  reap  a  profit  from  the  transaction  and 
will  run  no  risk  of  loss  from  fluctuations  in  the  rates  of  ex- 
change; for  the  bills  which  he  has  agreed  to  buy  will  offset 
those  he  has  agreed  to  sell.  To  make  sure  of  this  profit,  the 
banker  will  inform  himself  of  the  rate  his  own  future  will 
command  before  offering  a  price  to  the  merchant. 


lOR  FOREIGN  EXCHANGE 

A  variation  of  the  covered  future  is  found  in  those  trans- 
actions in  which  hankers'  futures  are  sokl  ap;ainst  i)urchases  of 
commercial  hills  of  various  maturities.  Thus,  when  a  New 
York  hanker  huys  an  assortment  of  sterling  hills  which  ma- 
ture at  different  future  dates,  he  can  determine  approxi- 
mately what  credit  the  bills  will  give  him  and  sell  now  his 
promise  to  deliver  a  corresponding  amount  of  demand  drafts 
oa  these  dates,  and  so  be  assured  of  his  ability  to  draw  upon 
profitable  terms  against  his  London  credits.  In  this  case, 
he  will  have  obtained  cover  for  his  future  in  advance  and 
will  have  eliminated  the  risk  of  fluctuation  in  the  exchange 
rates.  Such  dealings  in  covered  futures  do  not  seem  at  first 
sight  to  cause  a  real  addition  to  either  demand  or  supply  of 
bills  of  exchange,  since  each  transaction  afi'ects  both  sides  of 
the  market  equally.  But  they  none  the  less  contribute  to- 
ward the  development  of  a  broad  market  in  which  bills  may 
be  bought  and  sold  with  greater  confidence,  and  this  broaden- 
ing of  the  market  tends  to  prevent  the  excessive  pressure  of 
demand  or  supply  which  would  appear  periodically  if  business 
men  whose  transactions  involved  the  purchase  or  sale  of  bills 
of  exchange  were  denied  the  insurance  against  risk  afforded 
by  dealings  in  futures.  In  the  broader  and  more  stable  mar- 
ket, sudden  and  violent  fluctuations  in  the  rates  of  exchange 
are  prevented. 

Thus  far  we  have  considered  only  those  forms  of  specu- 
lation which  are  practiced  by  bankers  and  dealers  in  foreign 
exchange  as  an  incidental  part  of  their  regular  business. 
There  are  other  people  in  the  exchange  market  whose  sole 
activity  is  speculation  of  one  kind  or  another.  Some  of  these 
are  operators  in  the  stock  and  produce  exchanges  who  enter 
the  exchange  market  for  speculative  purposes  whenever  con- 
ditions appear  to  hold  forth  promise  of  profit  from  buying  or 
selling  bills  of  exchange;  others  are  from  the  outside,  people 
with  money  to  risk  in  a  gamble  on  the  trend  of  the  exchange 
rates,  who  buy  and  sell  more  or  less  blindly.  Speculators  of 
both  types  flourish  when  the  fluctuations  of  the  exchange 
rates  are  erratic;  their  profit  depends  upon  rapid  changes  in 
the  quotations  and  they  quickly  withdraw  from  a  quiet  or 


INTERRELATIONS  OF  THE  RATES  OF  EXCHANGE    107 

stable  market,  leaving  the  business  in  the  hands  of  the  regular 
bankers  and  dealers.  An  operator  whose  sole  purpose  is 
speculation  has  no  use  for  the  bills  of  exchange  which  he  buys, 
other  than  the  intention  to  sell  them  agam  at  a  higher  quo- 
tation; nor  has  he  any  power  to  add  to  the  supply  of  bills  by 
drawing  against  a  foreign  credit.  When  he  sells,  he  sells 
"short"  of  exchange;  that  is,  he  sells  a  promise  to  deliver 
bills  which  he  has  no  power  to  create,  relying  upon  a  drop  in 
the  exchange  rates  to  enable  him  to  buy  cover  upon  profitable 
terms  from  the  supply  already  in  existence.  These  activities 
appear  to  be  nothing  else  than  mere  gambling,  performing  no 
useful  function  to  society  and  wasting  the  time  and  energies, 
and  often  the  money,  of  those  who  practice  them.  But  this 
judgment  is  not  always,  nor  even  usually,  correct;  specula- 
tion in  bills  of  exchange  may  be  beneficial  to  society,  or  it  may 
be  harmful,  depending  upon  whether  the  speculators  have 
correctly  forecast  the  movement  of  the  rates. 

When  the  rates  of  exchange  are,  for  any  reason,  subject  to 
sudden  and  extreme  fluctuations,  the  speculators  attempt  to 
turn  the  situation  to  account  by  buying  in  bills  of  exchange 
when  they  expect  an  upward  turn  in  the  rates,  and  selling  short 
when  they  believe  the  tendency  is  downward.  If  their  pre- 
dictions are  substantiated  by  the  event,  the  fact  that  they 
have  bought  exchange  when  it  was  cheap  will  cause  them  to 
sell  on  the  rising  market;  while,  on  the  other  hand,  the  fact 
that  they  have  sold  short  when  the  rates  were  high  will  force 
them  to  buy  in  the  falling  market  to  cover  their  sales.  In 
either  case,  the  effect  of  their  operations  will  be  to  restrain 
the  fluctuations  of  the  rates,  since  they  will  have  added  to  the 
demand  when  prices  were  falling  and  to  the  supply  when 
prices  were  rising.  If,  however,  they  have  misjudged  the 
tendencies  and  have  bought  when  rates  were  about  to  fall,  or 
sold  short  when  rates  were  about  to  rise,  their  activities  will 
increase  the  fluctuations;  for  in  the  first  case,  they  will  be 
forced  to  sell  in  the  falling  market,  and,  in  the  second,  to  buy 
in  the  rising  market.  Ignorant  and  ill-conceived  speculation 
is,  therefore,  a  disturbing  factor  in  the  exchange  market;  but 
it  carries  ils  own  penalty,  since  the  speculator's  money  is  lost 


108  FOREIGN  EXCHANGE 

when  ho  niisjiidj:;cs  the  tendency  of  the  rates  of  exchange. 
On  the  other  hand,  when  the  speculator's  forecast  proves  to 
have  been  correct,  and  his  operations  result  in  profit  for  him- 
self, his  buyin<]j  or  selling  of  exchange  will  have  served  to  add 
stability  to  the  market  and  to  prevent  extreme  quotations. 
Since  the  Great  War,  the  market  for  European  bills  of  ex- 
change in  New  York  has  been  extremely  al)normal.  The  un- 
balanced trade  of  the  United  States  with  Europe,  coupled 
with  the  suspension  of  specie  payments  abroad,  has  flooded 
the  market  with  an  excessive  supply  of  commercial  bills,  a 
supply  which  the  bankers  have  been  unable  to  absorb,  and 
the  rates  have  fallen  to  unprecedented  discounts  These  ab- 
normalities have  been  a  temptation  to  the  speculators  in  ex- 
change, both  the  regular  operators  in  New  York  and  people 
from  the  outside.  There  is  reason  to  believe  that  their 
activities  have  been,  on  the  whole,  beneficial.  The  extreme 
movements  of  the  rates  have  not,  in  any  case,  been  caused  by 
the  speculators,  but  by  the  basic  forces  of  supply  and  demand; 
while  the  fact  that  the  low  rates  have  encouraged  speculative 
buying  has  brought  some  measure  of  relief  to  the  disturbed 
market  by  removing  a  portion  of  the  excess  supply  of  bills. 


CHAPTER  V 

TIIE  RATES  OF  EXCHANGE  AND  THE  CURRENTS 
OF  COMMERCE 

28.  Fluctuations  of  the  rates  caused  by  the  balance  of 
payment.  Two  forces  play  upon  the  rates  of  exchange  and 
cause  them  to  rise  above  or  fall  below  par.  One  of  these 
forces  may  be  properly  called  a  currency  factor;  it  is  brought 
into  play  by  the  breakdown  of  the  gold  standard  of  monetary 
payments  in  one  or  both  of  the  countries  to  which  the  rate 
applies,  and  the  inflation  of  that  country's  currency  through 
the  issue  in  excessive  amount  of  an  irredeemable  paper 
money.  The  other  force  may  be  called  a^ommemoi/aciOE; 
it^arisesfrom  the  balance  of  payment  between  the  two  na- 
tionsTeFTuncancelled  from  the  complex  of  transactions  which 
comprise  their  Joreign_  commerce.  We  shall  postpone  an 
examination  of  the  former  of  these  forces  to  a  later  place  in 
this  chapter.  In  the  discussion  which  follows,  it  will  be  as- 
sumed that  the  commercial  factor,  alone,  is  operative. 

The  statement  that  variations  of  the  rate  of  exchange  are 
caused  by  the  balance  of  international  commerce  is  correct 
only  when  the  term  commerce  is  used  in  its  broadest  sense  to 
include  all  transactions  which  require  payment  from  indi- 
viduals in  one  country  to  those  in  another.  These  trans- 
actions must  comprise  the  so-called  "invisible"  items  in 
foreign  trade  —  the  purchase  of  services  of  all  sorts,  the 
lending  of  capital  by  one  country  to  another,  remittances 
made  by  governments,  travelers,  immigrants,  and  so  forth  — 
as  well  as  the  importation  and  exportation  of  goods.  When, 
a  result  of  these  different  activities,  the  people  within  a  coun- 
try have  more  payments  to  make  to  foreign  creditors  than 
they  are  entitled  to  receive  from  foreign  debtors,  the  rates  in 
that  country  on  foreign  bills  of  exchange  will  rise,  while,  in 
other  markets,  the  rates  on  that  country's  bills  will  fall.    Con- 


110  FOREIGN  EXCHANGE 

vcrsoly,  when  the  people  within  a  country  have  more  pay- 
ments to  receive  than  to  make,  foreign  bills  will  be  quoted  at 
falling  rates  in  her  market,  while  bills  drawn  upon  her  will  be 
quoted  at  rising  rates  abroad.  This  controlling  factor,  the 
balance  of  paj'ment,  works  out  its  effect  through  the  medium 
of  the  bankers  whose  selling  rates  for  their  demand  drafts 
govern  the  exchange  market.  When  the  balance  is  in  the 
nation's  favor,  the  bankers  will  be  supplied  with  unused 
credits  in  foreign  cities  —  credits  placed  there  through  the 
purchase  of  the  bills  of  exporters  and  other  creditors;  unused, 
because  importers  and  other  debtors  will  have  discharged  all 
their  foreign  obligations  without  exliausting  the  bankers' 
foreign  balances.  In  an  effort  to  avail  themselves  of  these 
excess  credits,  the  bankers  will  offer  their  demand  drafts  at 
lower  rates  of  exchange.  On  the  other  hand,  when  the  bal- 
ance of  the  nation's  commerce  is  unfavorable,  the  bankers 
will  be  pressed  to  draw  foreign  drafts  faster  than  their  for- 
eign balances  can  be  repaired  through  the  purchase  of  ex- 
porters' bills;  their  reaction  to  this  situation  will  be  to  offer 
their  demand  drafts  at  advancing  rates  of  exchange. 

So  far  as  the  bankers  are  concerned,  the  rise  and  fall  of  the 
rates  of  exchange  exert  a  doubly  corrective  effect  upon  the 
condition  of  the  foreign  balance.  When  foreign  credits  are 
unduly  large,  the  falling  sight  rate  tends  to  expand  the  sale 
of  bankers'  demand  drafts  by  means  of  which  these  credits  are 
reduced,  and  to  retard  the  offerings  of  exporters'  bills  by 
means  of  which  they  are  increased.  Conversely,  the  rising 
rate,  when  foreign  credits  are  unduly  small,  diminishes  the 
demand  for  bankers'  sight  drafts  and  stimulates  the  offerings 
of  bills  for  sale  to  the  bankers.  But,  since  the  basic  cause  of 
the  condition  of  the  bankers'  foreign  credits  is  an  unbalanced 
state  of  the  nation's  foreign  commerce,  the  only  effectual  cor- 
rective is  to  bring  this  commerce  more  nearly  to  a  state  of 
equilibrium.  So  long  as  the  people  within  the  country  con- 
tinue to  buy  more  than  they  sell  (measuring  both  imports  and 
exports  in  terms  of  value),  or  to  sell  more  than  they  buy,  for- 
eign credits  must  remaui  either  scarce  or  redundant,  and  the 
rates  of  exchange  must  be  held  more  or  less  permanently  at  a 


THE  RATES  OF  EXCHANGE  111 

premium  or  a  discount.  This  shows  the  significance  of  the 
specie  points.  When  other  correctives  fail  to  restore  to  equi- 
Hbrium  the  foreign  commerce  of  the  nation,  gold  will  move  in 
sufficient  quantities  to  offset  the  balance,  flowing  out  of  the 
country  whose  purchases  of  all  sorts  so  far  outweigh  her  sales  as 
to  force  the  exchange  rates  on  foreign  bills  to  the  specie  export- 
ing point ;  and  into  the  country  whose  sales  exceed  her  pur- 
chases so  much  that  the  rates  fall  to  the  specie  importing  point. 

Irresistible  economic  forces  are,  therefore,  working  to  bring 
the  foreign  commerce  of  the  nation  to  a  balance;  no  group  of 
producers  will  be  content  to  give  away  its  goods,  service,  or 
property  rights;  payment  in  some  form,  or,  at  least,  satis- 
factory promise  of  payment,  will  be  insisted  upon.  A  rising 
exchange  rate  on  a  nation's  bills  is  an  indication  that  that 
nation  has  been  selling  to  foreign  peoples  more  than  it  has 
received  payment  for;  the  reverse  is  shown  by  a  falling  rate  on 
a  nation's  bills;  either  condition  is  abnormal  and  temporary. 

29.  Reaction  of  the  rates  of  exchange  upon  the  currents  of 
trade.  This  explanation  of  the  commercial  forces  which 
cause  fluctuations  of  the  rates  of  exchange  exhibits  these 
fluctuations  as  the  result  of  variations  in  the  currents  of  inter- 
national commerce.  But  the  relation  between  the  rates  of 
exchange  and  the  foreign  commerce  of  a  nation  is  not  a  simple 
one;  we  have  now  to  see  that  the  rates,  caused  by  the  balance 
of  payment,  react  upon  the  currents  of  commerce  and  produce 
changes  in  the  balance  of  payment.  When  foreign  bills  are 
at  a  discount  in  the  New  York  market,  the  low  rates  of  ex- 
change tend  to  stimulate  imports  and  to  restrict  exports  in 
the  foreign  trade  of  the  United  States,  and  thus  to  reduce  the 
favorable  balance  of  trade  which  is  the  initial  cause  of  the 
discount;  conversely,  a  premium  on  foreign  bills  acts  as  a 
stimulus  to  exports  and  a  restriction  upon  imports,  tending 
in  this  manner  to  reduce  the  unfavorable  balance  of  pay- 
ment. Under  normal  conditions,  when  gold  is  moving  freely 
between  the  nations,  and  the  rates  of  exchange  are  confined 
within  the  narrow  range  set  by  the  specie  points,  this  re- 
action of  the  rates  upon  the  balance  of  payment  may  be  im- 
perceptible; but  when  the  limits  are  removed  and  the  rates 


112  FOREIGN  EXCHANGE 

arc  permit  ted  to  move  to  abnormal  premiums  or  discounts  — 
anil  this  has  heen  true  the  world  over  since  the  Great  War  — 
their  influence  upon  the  currents  of  international  commerce 
becomes  api)arent  and  important. 

The  reaction  of  the  exchange  rates  upon  the  nation's  com- 
merce will  become  clear  if  we  place  ourselves  in  the  position 
of  a  merchant  whose  business  brings  him  into  the  exchange 
market  as  a  buyer  or  seller  of  bills,  and  consider  the  effect  of 
the  position  of  the  exchange  rates  upon  his  transactions.  Let 
us  assume  that  this  typical  merchant  is  trading  with  Great 
Britain  at  a  time  when  sterling  bills  are  selling  at  a  premium 
in  New  York.  With  exchange  in  this  position,  the  merchant 
may  make  a  double  profit  from  his  sales  in  England.  His 
normal  trading  profit  is  included  in  the  sale  price  of  his  goods 
and  is,  therefore,  included  also  in  the  face  of  the  sterling  draft 
which  he  draws.  In  turning  this  draft  into  dollars  at  the  pre- 
vailing high  rate  of  exchange,  a  second  profit  is  derived  from 
the  fact  that  each  pound  sterling  is  worth  more  dollars  than 
normally.  Now,  if  the  merchant  is  free  from  competition,  he 
can  retain  this  double  profit  for  himself,  and  he  will,  accord- 
ingly, have  an  increased  incentive  to  sell  goods  in  England. 
If,  however,  as  is  usually  the  case,  he  is  in  active  competition 
with  other  exporters,  the  profitable  market  for  American 
goods  in  England  will  result  in  lower  sale  prices  to  the  benefit 
of  English  buyers;  but  this  condition,  also,  will  increase  our 
exports,  since  it  is  axiomatic  that  more  goods  can  be  sold  at  a 
low  than  at  a  high  price.  The  same  result  —  increased  ex- 
ports from  the  United  States  to  England  —  will  occur  if  pay- 
ment is  made  by  remittance  of  dollar  drafts  by  the  English 
buyers;  for  when  sterling  exchange  is  at  a  premium  in  New 
York  dollar  bills  sell  at  a  corresponding  discount  in  London, 
and  the  purchase  of  these  bills  at  low  rates  by  English  im- 
porters as  a  means  of  making  payment  for  American  goods 
reduces  the  cost  of  the  goods  and  encourages  their  importation. 
As  an  exporter,  the  New  York  merchant  either  gains  an  un- 
usual profit  when  sterling  rates  are  high  or  finds  his  goods  in 
larger  demand  because  their  cost  has  fallen;  in  either  event 
the  high  rates  stimulate  his  foreign  sales. 


THE  RATES  OF  EXCHANGE  113 

The  position  of  the  importers  of  EngHsh  goods  is  the  exact 
reverse  when  sterling  exchange  sells  at  a  premium.  Pay- 
ment will  be  made  by  the  importer,  either  by  remittance  of 
sterling  sight  drafts  from  this  side,  or  by  the  redemption  of  a 
bill  drawn  in  dollars  by  the  English  exporter.  If  the  former 
method  be  adopted,  the  cost  of  English  goods  to  the  im- 
porter will  rise,  even  when  the  price  quoted  by  the  seller  does 
not  change;  for  the  premium  on  sterling  drafts  must  be  paid 
when  the  importer  buys  exchange  to  discharge  his  obligation 
under  the  terms  of  sale,  and  this  virtually  increases  the  cost 
price  of  his  goods.  Similarly,  if  payment  is  made  by  draft  of 
the  exporter,  the  premium  on  sterling  exchange  will  increase 
the  costs  of  the  goods  to  the  importer.  In  this  case,  there 
will  probably  be  a  definite  and  open  rise  in  the  sale  price 
quoted  by  the  English  exporter;  for  he  will  expect  to  receive 
a  certain  amount  in  pounds  for  each  unit  of  his  goods,  and, 
when  dollars  are  at  a  discount,  he  must  raise  his  selling  price, 
quoted  in  dollars,  in  order  to  be  assured  of  a  profit.  Under 
either  situation,  therefore,  the  premium  on  sterling  exchange 
tends  to  restrict  imports  into  the  United  States  from  England. 
It  has  been  said  above  that  these  influences  of  the  rates  of 
exchange  upon  the  currents  of  trade  are,  under  normal  con- 
ditions, so  slight  as  to  be  imperceptible.  It  should  be  borne 
in  mind,  however,  that  this  is  true  only  because  gold  is  per- 
mitted to  move  in  sufficient  quantities  to  restore  equilibrium 
in  international  commerce;  when,  from  economic  necessity  or 
national  policy,  gold  is  prevented  from  supplying  this  cor- 
rective, the  exchange  rates  will,  themselves,  exert  the  needed 
corrective  influence  through  their  tendency  to  increase  im- 
ports and  diminish  exports,  or  vice  versa.  It  is  a  simple  and 
fundamental,  but  frequently  forgotten,  law  of  international 
trade  that  payments  must  balance, 

30.  Fluctuations  of  the  rates  caused  by  a  depreciated  cur- 
rency. The  rates  of  exchange  are  prices  for  a  particular  kind 
of  credit  instrument,  and,  like  all  other  prices,  are  controlled 
solely  by  the  forces  of  supply  and  demand.  Only  the  com- 
merce of  the  nation  —  using  that  term  in  its  broadest  sense  — 
can  affect  either  the  supply  of  bills  of  exchange  or  the  demand 


114  FOREIGN  EXCHANGE 

for  them;  honce,  all  true  fluctuations  in  the  rates  of  exchange 
must  be  attributed  to  the  commercial  factor  discussed  in  the 
prcccdiiifj  section.  But  apparent  fluctuations  are  caused  by 
another  factor  —  the  presence  in  one  or  both  of  the  nations 
concerned  of  an  inflated  and  irredeemable  paper  money;  and, 
unfortunately,  no  attempt  is  made  in  the  exchange  markets 
to  distinguish  these  apparent  fluctuations  from  those  move- 
ments which  have  a  commercial  origin.  Yet  they  are  es- 
sentially different  both  in  their  nature  and  in  their  reactions 
upon  the  currents  of  trade  between  nations  and  it  is  impor- 
tant that  this  difference  be  understood.  When  discussing 
this  subject  in  another  chapter,^  we  tried  to  make  clear  the 
fact  that  a  discount  on  a  nation's  bills  which  appears  in  for- 
eign markets  when  that  nation  is  using  a  depreciated  paper 
currency,  is  not  a  true  discount,  but  an  indication  of  a  new  par 
rate. 

Whether  the  true  par  of  exchange  between  gold  money  and 
an  irredeemable  paper,  or  between  the  irredeemable  paper 
notes  of  two  countries,  is  calculated  on  the  basis  of  the  pre- 
mium on  gold  or  on  the  basis  of  the  relative  purchasing  powers 
of  the  two  moneys,^  the  fact  must  be  recognized  that  the 
paper  notes  are  essentially  different  from  the  gold  coins  whose 
names  they  commonly  bear.  Any  inferences  regarding  the 
effect  of  exchange  rates  upon  the  currents  of  trade  under  these 
conditions  wnll  be  unsound  so  long  as  they  proceed  from  the 
assumption  that  the  gold  pars  of  exchange  are  still  of  signifi- 
cance. ^^'hen  the  new  par  of  exchange  is  derived  for  the  pur- 
pose of  throT\ang  light  upon  the  trade  relations  of  the  coun- 
tries concerned,  it  is  safer  to  base  the  calculation  upon  the 
purchasing  power  parities.  Business  men  are  primarily  con- 
cerned with  costs  and  receipts  determined  by  the  purchase 
and  sale  prices  of  their  goods;  they  will  be  encouraged  to  in- 
crease their  exports  to  a  given  country,  or  their  imports  from 
that  country,  by  reason  of  the  condition  of  the  exchange 
market,  only  if  the  exchange  rates  so  affect  their  transactions 
as  to  increase  the  spread  between  purchase  and  sale  prices  so 
that  their  profits  expand..^ 

*  See  pages  51  f.  *  See  pages  52  f. 


THE  RATES  OF  EXCHANGE  115 

The  peculiarity  of  foreign  trade  in  this  respect  is  this :  that 
purchase  prices,  on  the  average,  are  determined  by  the  price 
level  of  one  country,  while  sale  prices,  on  the  average,  are 
determined  by  the  price  level  of  another  country.  Hence, 
for  the  spread  to  increase  between  these  two  prices,  thus 
widening  the  margin  of  profit  between  the  costs  and  receipts 
of  the  foreign  traders,  the  price  levels  of  the  two  countries 
must  draw  apart;  that  is  to  say,  the  purchasing  powers  of 
their  moneys  must  diverge.  But  if,  when  such  a  divergence  of 
the  price  levels  occurs,  the  difference  is  all  taken  up  by  move- 
ments of  the  rates  of  exchange,  the  effect  upon  the  trade  re- 
lations of  the  countries  will  be  neutralized.  The  temptation, 
then,  will  be  to  take  note  only  of  the  abnormal  position  of  the 
exchange  rates,  and,  overlooking  the  fact  that  any  influence  of 
these  rates  is  offset  by  the  relation  of  the  price  levels  of  the 
two  countries,  to  infer  that  the  exchange  market  must  be 
exerting  a  powerful  influence  either  in  the  direction  of  stim- 
ulating imports  or  exports.  Both  of  these  factors  must  be 
taken  into  account  at  a  time  when  trade  relations  are  com- 
plicated by  the  presence  of  an  irredeemable  paper  money. 
The  best  way  of  doing  this  is,  first,  to  compute  the  true  par  of 
exchange  on  the  basis  of  the  relative  purchasing  powers  of  the 
two  moneys  and  then  to  compare  the  current  market  rates 
with  this  new  par.  If  any  discrepancy  appears,  it  may  be 
called  a  true  discount  or  a  true  premium  on  the  foreign  bills, 
and,  since  its  origin  must  be,  not  in  the  currency,  but  in  the 
commercial  factor,  it  will  exert  an  influence  over  the  cur- 
rents of  trade  between  the  two  nations. 

We  can  best  understand  why  it  is  that  fluctuations  of  the 
rates  of  exchange,  produced  by  the  influence  of  an  inflated 
currency,  exert  no  effect  upon  the  currents  of  trade,  by  plac- 
ing ourselves  in  the  position  of  a  merchant  engaged  in  foreign 
commerce  at  a  time  when  the  exchange  market  is  disturbed  by 
this  factor.  Assume  that  the  franc  rate  in  New  York  shows  a 
discount  from  the  gold  par  of  50  per  cent  at  a  time  when  the 
purchasing  power  parity  of  the  paper  franc  is  exactly  50  per  cent 
below  the  normal  par.  An  exporter  of  goods  from  France  to 
America  can  now  sell  his  dollar  bills  at  a  premium  of  100  pOT 


116  FOREIGN  EXCHANGE 

cent;  hut  he  will  receive  paper  francs  in  cxcliange  for  these 
bills  and  must  use  this  paper  money  to  meet  costs  whicli  have 
douMcd.  Each  franc  has  half  the  purchasing  power  that  it 
normally  possessed;  hence,  the  fact  that  the  exporter  receives 
for  his  dollar  hills  twice  as  many  francs  as  normally  will 
not  avail  to  increase  his  profit  from  the  sale  of  goods  to  the 
United  States.  There  will  be  no  inducement  for  him  to  lower 
the  sale  price  of  his  goods,  and  we  can  conclude  that  the 
condition  of  the  exchange  market  will  exert  no  stimulus  upon 
French  exports  to  the  United  States.  A  French  importer  of 
American  goods,  on  the  other  hand,  itnust  now  pay  twice  as 
many  francs  as  normally  when  buying  dollar  drafts  with  which 
to  make  payment  for  his  imports.  But  under  the  assump- 
tion that  the  premium  on  dollar  bills  exactly  measures  the 
discrepancy  between  the  price  levels  of  the  United  States  and 
France,  this  importer  will  also  receive  twice  as  many  francs, 
as  he  normally  received,  when  he  sells  his  goods  in  the  French 
market.  Hence,  the  condition  of  the  exchange  market  will 
not  diminish  his  profit,  and,  therefore,  will  not  tend  to  restrict 
his  importation  of  American  goods.  It  need  not  be  urged 
that  we  speak  here  of  the  import  and  export  trade  in  general; 
dealers  in  a  narrow  range  of  goods  may  well  find  that  the 
prices  of  their  particular  commodities  have  not  kept  pace 
with  the  trend  of  the  general  price  level  and  that,  conse- 
quently, the  condition  of  the  exchange  market  is  such  as  either 
to  stimulate  or  to  burden  their  trade.  But  considering  the 
commerce  of  the  nations  as  a  whole,  the  effects  will  be  as 
stated;  when  the  fluctuations  of  the  exchange  rates  conform 
to  the  purchasing  power  parities,  no  influence  will  be  exerted 
upon  the  currents  of  trade. 

31.  The  silver  exchanges  and  their  relation  to  international 
commerce.  Another  type  of  currency  factor  is  to  be  found  in 
the  case  of  the  silver  exchanges.  The  relations  of  a  gold  stand- 
ard country  with  a  silver  standard  country  are  very  similar  to 
its  relations  with  a  country  whose  money  is  an  irredeemable 
paper  in  that  in  both  cases  there  is  a  fluctuating  par  of  ex- 
change and  the  market  rates  are  subject  to  wide  variation  due 
to  this  fact.     In  both  cases,  also,  there  is  the  temptation  to 


THE  RATES  OF  EXCHANGE  117 

draw  hasty  conclusions  from  the  evidence  of  the  exchange 
rates  regarding  the  profitableness  of  export  and  import  trade 
with  the  nation  concerned.     Between  June,  1918,  and  June, 

1919,  for  example,  the  market  rates  in  New  York  on  Shanghai 
exchange  rose  from  $113.50  for  100  taels  to  $127.00  for  100 
taels;  during  the  following  year,  from  June,  1919,  to  June, 

1920,  this  rate  fell  from  $127.00  to  $101.00.  With  attention 
fixed  solely  on  these  quotations,  one  might  readily  deduce 
that  the  movement  of  the  rates  during  the  first  of  these  two 
years  was  such  as  to  encourage  the  sale  of  goods  in  China  and 
discourage  importations  from  that  country,  while,  during  the 
second  year,  a  reverse  effect  was  exerted  by  the  rates.  But 
this  conclusion  would  be  founded  upon  insufficient  evidence. 
It  must  be  remembered  that  the  price  levels  in  these  two 
countries  —  the  United  States  and  China  —  are  not  ex- 
pressed in  a  common  denominator  and  that  their  fluctuations 
are  not  of  necessity  uniform.  Any  effect  exerted  by  the  ex- 
change rates  might  he  counterbalanced  or  more  than  counter- 
balanced by  offsetting  movements  of  the  price  levels  of  the 
two  countries,  in  the  same  manner  as  that  discussed  in  the 
preceding  section  with  reference  to  the  paper  standard  coun- 
tries. With  the  silver  exchanges  as  with  the  paper  money 
exchanges,  the  movements  of  the  rates  must  be  compared 
with  movements  of  the  purchasing  power  parities  of  the  two 
moneys  before  reliable  conclusions  can  be  drawn  regarding 
the  effect  of  the  exchange  market  upon  the  currents  of  com- 
merce. The  statement  may  be  repeated  in  this  regard,  that 
only  true  discounts  or  true  premiums  react  upon  the  profit- 
ableness of  trade. 

In  concluding  this  subject  of  the  influence  of  the  cur- 
rency factor,  we  may  introduce  one  qualification.  It  has 
been  said  that  when  fluctuations  of  the  exchange  rates  con- 
form to  changes  in  the  purchasing  power  parities  of  the 
moneys  concerned,  no  influence  is  exerted  upon  the  currents 
of  trade.  This  is  the  long-run  view  of  the  matter.  But  there 
is  a  short-run  effect  which  should  not  be  left  out  of  account. 
After  an  exporter  has  named  his  price  and  sold  his  goods,  any 
shift  in  the  exchange  rates  quoted  for  the  bills  he  is  to  draw 


118  FOREIGN  EXCHANGE 

will  either  increase  or  decrease  his  profit;  and  this  will  be 
true  even  though  the  shift  in  the  exchange  rates  conforms 
precisely  to  changes  in  the  purchasing  power  parity  of  the  two 
moneys.  For  this  particular  exporter,  in  this  particular 
transaction,  the  changing  price  level  is  of  no  moment,  since 
Iiis  goods  have  already  been  priced.  If  the  foreign  rates  fall 
before  he  can  liquidate  his  transaction,  a  part  of  his  profit 
will  disappear  in  the  exchange  market.  Individual  im- 
porters are  in  a  similar  position  with  respect  to  particular 
transactions.  It  is  often  the  custom  to  agree  to  pay  a  certain 
price  for  future  delivery  and  even  to  resell  the  goods  in  the 
home  market  on  the  basis  of  that  price.  When  a  contract  of 
this  kind  has  been  formed  and  the  exchange  rates  suddenly 
shift,  the  importer  \^^ll  either  lose  or  gain  profit  when  making 
remittances  to  his  foreign  creditors.  Sudden  and  violent 
fluctuations,  produced  by  the  currency  factor,  will  almost  of 
a  certainty  find  a  multitude  of  importers  and  exporters  with 
commitments  made  on  the  basis  of  past  rates  of  exchange. 
It  is  possible  to  guard  against  these  risks  by  selling  or  buying 
for  future  delivery  in  the  exchange  market  the  bills  of  ex- 
change which  will  figure  as  the  financing  agencies  of  the  trans- 
actions about  to  be  formed,  thus  informing  the  merchant  of 
the  rates  of  exchange  at  which  he  will  realize  upon  his  trans- 
actions.^ But  unless  this  is  done,  the  unstable  condition  of 
the  exchange  market  will  inject  a  large  element  of  risk  into  the 
transactions  of  the  traders.  It  cannot  be  said  that  this  short- 
term  effect  of  the  currency  factor  stimulates  exports  or  im- 
ports; rather  its  effect,  unless  guarded  against,  is  to  discourage 
both  import  and  export  trade  and  thus  to  exert  a  repressing 
influence  upon  foreign  commerce.  For  this  reason  it  is  not  a 
matter  of  indifference  when  rates  on  silver  or  paper  standard 
countries  are  shifting  rapidly,  even  though  these  fluctuations 
are  neither  true  discounts  nor  true  premiums. 

32.  National  interest  as  affected  by  fluctuations  of  the 

rates  of  exchange.    We  have  seen  that  when  exchange  drawn 

on  a  country  sells  at  a  true  premium  in  foreign  markets  — 

and  foreign  bills  at  a  true  discount  in  her  own  —  the  situation 

*  See  the  discussion  of  hedging,  pages  293  f. 


THE  RATES  OF  EXCHANGE  119 

is  one  which  encourages  the  importation  of  foreign  goods  and 
discourages  exports.  Conversely,  that  exports  are  stimu- 
lated and  imports  restricted  when  the  rates  on  a  nation's  bills 
fall  to  a  discount  in  foreign  markets.  It  is  customary  to 
speak  of  the  first  of  these  conditions  as  favorable  to  the  nation, 
and  of  the  second  as  unfavorable.  The  reason  is  that,  nor- 
mally, when  foreign  rates  fall  in  the  home  market,  there  is 
likelihood  of  an  inflow  of  gold,  whereas  when  they  rise,  an  out- 
flow of  gold  may  occur;  and  these  events  are  supposed  to  be, 
the  one  desirable,  the  other  undesirable,  from  the  standpoint 
of  national  interest.  However,  a  little  thought  should  make 
it  clear  that  no  nation  is  benefited  by  an  abnormal  condition 
of  the  exchange  market,  whether  that  condition  is  such  as  to 
cause  a  premium  or  a  discount  on  its  bills  in  foreign  countries. 
When  we  view  the  matter  from  the  standpoint  of  the  nation 
as  a  whole,  and  disregard  the  interest  of  the  individual 
traders,  the  rise  and  fall  of  the  rates  of  exchange  indicate 
fluctuations  of  the  nation's  power  to  buy  the  goods  of  other 
peoples.  Nations  export  to  be  enabled  to  import:  purchases 
of  foreign  goods  and  services  are  paid  for  out  of  credit  supplied 
by  the  export  trade.  When  the  exchange  rates  move  against 
a  nation  —  that  is  to  say,  when  her  bills  fall  to  a  discount  iu 
foreign  markets  —  the  credits  created  by  her  export  trade 
shrink  accordingly,  and  the  exports  will  exchange  for  a  pro- 
portionately smaller  amount  of  foreign  goods  and  services. 
To  illustrate:  Brazil  pays  for  her  imports  from  the  United 
States,  in  large  measure,  by  exporting  coffee.  In  making  pay- 
ment for  their  purchases  of  Brazilian  coffee,  American  buyers 
create  credits  in  New  York  in  favor  of  banks  in  Brazil,  and 
drafts  are  drawn  against  these  credits  for  the  use  of  Brazilian 
importers  who  have  payments  to  make  for  goods  bought  in 
the  United  States.  If  exchange  on  Brazil  falls  to  a  great  dis- 
count in  New  York,  as  it  did  in  the  year  1920,  less  will  be  paid 
by  the  importers  of  coffee  when  purchasing  bills  for  remit- 
tance to  Brazil  and,  therefore,  smaller  credits  will  be  created 
out  of  which  to  pay  for  American  goods;  in  other  words,  a 
given  amount  of  coffee  will  exchange  for  a  smaller  amount  of 
the  products  of  the  United  States.    This  state  of  affairs  can- 


120  FOREIGN  EXCHANGE 

not  he  called  favorable  to  the  interests  of  Brazil,  certainly; 
although  she  may  be  able  to  increase  her  sales  of  coffee  be- 
cause the  price  of  that  article  measured  in  dollars  has  fallen, 
no  corresponding  increase  of  American  goods  is  given  in  ex- 
change for  the  larger  shipments  of  cofYee.  Nations,  like  indi- 
viduals, are  impoverished  by  a  dwindling  of  their  purchasing 
power. 

On  the  other  hand,  it  is  not  beneficial  to  the  interests  of  the 
United  States  that  the  dollar  rate  should  rise  to  abnormal 
premiums  in  Brazil  and  other  foreign  markets.  The  premium 
on  the  dollar  —  if  a  true  premium,  and  not  merely  the  effect 
of  an  inflated  currency  in  other  countries  —  will  reduce  the 
power  of  American  exporters  to  sell  their  goods  abroad.  But 
when  a  nation  has  come  to  rely  upon  foreign  markets  for  the 
sale  of  a  part  of  her  product,  a  loss  or  diminution  of  her  power 
to  export  cannot  occur  without  shock  to  her  industrial  struc- 
ture. In  the  United  States,  an  important  part  of  the  cotton 
and  cereal  crops  —  known  as  the  export  surplus  —  must  find 
outlet  abroad  if  the  price  of  these  commodities  is  not  to  break 
to  levels  so  low  as  to  cause  loss  to  the  planters  and  farmers. 
Moreover,  the  producers  of  these  great  crops  constitute  the 
largest  group  of  buyers  within  the  nation  of  the  products  of 
domestic  manufactures;  when  they  stop  or  curtail  their  buy- 
ing, a  depressing  effect  upon  the  industry  of  the  entire  country 
is  immediately  felt.  This  interdependence  between  the  pro- 
ducing groups  of  the  country  makes  any  sudden  loss  of  for- 
eign markets  for  our  staple  crops  a  national  calamity,  w^hose 
ultimate  effects  are  depression  in  the  domestic  market,  loss  of 
profit  to  manufacturers,  and  unemployment  to  workingmen. 

That  a  nation  is  injured  by  a  situation  which  causes  its  ex- 
change to  sell  at  too  high  a  price  in  foreign  markets  may  be 
seen,  also,  from  another  point  of  view.  Granting  that  the 
prevailing  antagonism  against  imported  goods  is  based  upon 
unsound  reasoning,  and  that  a  nation  gains  from  an  unre- 
stricted import  trade,  it  remains  true,  nevertheless,  that 
floods  of  imports  artificially  induced  at  irregular  intervals  by 
a  breakdown  of  the  exchange  market  is  disruptive  of  the 
domestic  market.    A  bounty  on  imports  is  at  least  as  vicious 


THE  RATES  OF  EXCHANGE  121 

in  its  economic  effects  as  is  a  protective  tariff  which  burdens 
imports  with  restrictive  taxes.  A  premium  on  a  nation's 
bills  in  foreign  markets  acts,  as  we  have  seen,  as  a  bounty  on 
imports.  The  experience  of  the  United  States  with  this  situ- 
ation following  the  Great  War  has  proved  without  doubt  that 
too  great  a  premium  on  dollar  bills  can  be  anything  but 
"favorable"  to  the  business  of  the  country.  INIeeting  com- 
petition from  foreign  producers  whose  goods  were  artificially 
cheapened  in  the  American  market  by  the  condition  of  the 
exchanges,  the  manufacturers  within  the  country  have 
frequently  asserted  their  inability  to  continue  operations 
and  have  appealed  for  aid  to  the  Federal  Government.  In 
many  other  countries,  as  well  as  our  own,  special  tariff  legis- 
lation—  "anti-dumping"  taxes,  and  so  forth  —  has  been 
projected  as  a  protection  against  that  condition  of  the  ex- 
change market  which  is  customarily  called  "favorable  to  the 
natian, " 

The  truth  is  that  one  country  gains  from  the  prosperity, 
not  the  adversity,  of  another.  Any  calamity  which  destroys 
one  nation's  productivity,  impoverishes  her  people,  and  cur- 
tails her  power  to  buy  the  products  of  other  nations,  immedi- 
ately upsets  the  balance  of  international  commerce,  and 
sooner  or  later,  makes  its  effects  felt  in  all  the  exchange  mar- 
kets of  the  world.  Individuals  in  other  countries  may  seize 
the  opportunity  to  take  for  themselves  the  markets  which 
producers  in  the  nation  suffering  misfortune  have  been  com- 
pelled to  relinquish;  to  them  the  calamity  which  has  de- 
stroyed their  competitors  may  seem  an  unmixed  blessing,  but 
their  gains  will  be  more  than  offset  by  the  general  handicap  to 
commerce  which  their  country  shares  in  common  with  all 
others.  Unbalanced  trade  cannot  persist  for  any  length  of 
time  without  providing  its  own  corrective  in  the  form  of 
burdensome  rates  of  exchange.  In  a  normal  market,  oc- 
casional shifts  in  the  balance  of  payment  will  be  oft'set  by  au 
outflow  of  gold,  or  an  inflow,  as  the  case  may  be;  but  when 
the  unbalanced  state  of  commerce  is  caused  by  a  factor  of 
fundamental  and  far-reaching  inii)orlance  —  as,  for  example, 
by  the  prostration  of  Europe  following  the  Great  War  — 


K2  FOREIGN  EXCHANGE 

those  normal  correctives  fail  of  their  effect,  and  the  rates  of 
exchange  will  so  influence  the  imports  and  exports  of  the 
country  as  ultimately  to  restore  the  balance  in  its  foreign 
coniniercc. 

33.  The  embargo  on  gold.  Nations  are  sometimes  tempted 
to  i)rohil)it  the  exportation  of  gold  when  the  balance  of  trade 
is  against  them.  This  policy  has  some  justification  in  times 
of  unusual  credit  stringency  when  there  is  imminent  danger 
that  the  banks  or  the  Government  may  be  forced  to  suspend 
specie  payment  through  a  lack  of  adequate  gold  reserves;  but 
the  widespread  fallacies,  so  prevalent  and  so  deeply  rooted  in 
the  common  mind,  concerning  the  relation  of  the  gold  stock  to 
the  wealth  of  the  nation,  cause  an  urging  of  this  policy  upon 
the  Government  when  no  such  justification  exists.  Thus, 
when  the  embargo  on  gold  was  lifted  in  the  United  States  in 
June  of  the  year  1919,  there  was  much  outcry  against  the 
decision  of  the  Government  to  interfere  no  longer  in  the  free 
movement  of  the  precious  metal  from  our  country.  At  that 
time  the  foreign  trade  of  the  United  States  was  in  a  peculiarly 
distorted  condition ;  exports  vastly  outweighed  imports  in  the 
total  trade  statement,  but  our  favorable  balance  was  prac- 
tically limited  to  our  commerce  with  Europe,  while  imports 
preponderated  in  our  trade  with  the  rest  of  the  world,  and 
especially  with  the  Far  East.  Europe  was  unable  to  send 
gold  in  any  quantity  in  payment  of  her  balance  owing  here, 
whereas  our  decision  to  permit  gold  exportation  immedi- 
ately set  in  motion  a  current  of  specie  toward  Japan  and 
China.  This  loss  of  gold  appeared  to  many  people  to  be 
detrimental  to  the  economic  welfare  of  the  country  and  at- 
tempts were  made  to  reinstitute  the  embargo.  In  such  a 
situation  as  this,  it  should  be  clear  that  any  unnecessary 
interference  with  the  functioning  of  the  exchange  market 
must  react  to  the  injury  of  the  country  as  a  whole. 

It  is  not  necessary  to  consider  at  length  all  the  reasons  why 
interference  with  the  free  movement  of  gold  between  the 
nations  is  unwise.  It  is,  for  example,  beneficial  to  the  credit 
of  a  nation  to  acquire  an  international  reputation  for  prompt 
and  willing  payment  of  all  obligations  on  demand.    London's 


THE  RATES  OF  EXCHANGE  123 

position  of  supremacy  among  the  exchange  markets  of  the 
world,  a  position  which  has  reacted  favorably  upon  British 
traders  by  increasing  the  ease  with  which  they  have  financed 
their  transactions  and  improving  the  credit  terms  accorded 
them  by  foreign  sellers,  has  rested  in  part  upon  her  long  his- 
tory as  a  free  gold  market.  No  other  city  can  attain  a  sim- 
ilar preeminence  as  long  as  a  chance  remains  that  specie  pay- 
ment of  foreign  obligations  will  be  st  opped  without  compelling 
cause.  Whatever  economic  advantage  the  business  men  of 
the  United  States  might  gain  from  an  extension  of  the  use  of 
dollar  credits,  and  the  position  of  New  York  as  an  inter- 
national money  center,  can  be  lost  through  any  injury  to  our 
credit  caused  by  arbitrary  governmental  interference  in  the 
movement  of  gold.  Disregarding  these  considerations,  how- 
ever, there  remain  other,  and  more  fundamental,  reasons 
why  an  embargo  on  gold  should  not  be  adopted  except  as  a 
last  resort.     We  shall  consider  two  of  these  reasons. 

In  the  first  place,  when  the  exchange  rates  have  risen  to  the 
gold  exporting  point,  the  shipment  of  gold  has  become  the 
cheapest  form  of  payment  available  to  the  nation.  We  may 
repeat  that  the  rates  will  rise  to  this  premium  only  when  the 
nation  is  in  debt  on  the  current  balance  of  trade  and  must 
make  payment  to  foreign  creditors  in  one  form  or  another. 
To  prevent  gold  from  leaving  the  country  under  these  con- 
ditions will  remove  the  check  upon  the  rising  rates,  permit- 
ting the  premium  to  go  to  abnormal  lengths,  until  a  gradual 
and  more  or  less  painful  readjustment  of  exports  and  imports 
brings  commerce  into  equilibrium.  While  tbis  process  is 
under  way,  the  entire  import  trade  of  the  nation  will  be  taxed 
by  the  burdensome  premium  charge,  and  the  nation  as  a 
whole  will  bear  a  heavy  cost  as  a  consequence  of  its  own 
refusal  to  discharge  its  obligations  in  specie.  In  comparison 
with  this  widespread  burden,  the  shipment  of  gold  affords  a 
much  more  economical  method  of  payment. 

In  explanation,  let  us  assume  that  the  sterling  sight  rate  has 
risen  to  a  position  slightly  above  the  specie  point  and  that 
gold  has  begun  to  leave  the  country.  From  the  standpoint 
of  the  bankers  who  supply  the  market  with  sterling  demand 


Ul  FOREIGN  EXCHANGE 

drafts,  tlicrc  can  lie  no  doubt  that  it  is  now  clieapcr  to  make 
paynuMifs  to  London  in  j^old  ralluT  llian  in  hills  of  oxclian<;e; 
in  fact,  the  specie  point  on  sterlinjj;  exchange  is  dclerniincd  by 
this  very  comparison  of  the  relative  costs  of  the  two  modes  of 
payment,  being  set  at  the  quotation  at  which  gold  shipments 
become  the  cheaper.  A  prohibition  of  gold  shipment  will 
force  all  debtors  to  England  to  adopt  the  dearer  method  of 
payment,  and,  as  their  competition  drives  the  sterling  rates 
above  the  specie  point,  the  cost  involved  in  the  employment 
of  this  more  expensive  means  of  payment  will  grow  continu- 
ally heavier.  All  importers  of  English  goods,  therefore,  will 
be  penalized  when  buying  drafts  to  pay  debts  previously  con- 
tracted. But  the  evil  will  spread  further  until  a  similar 
burden  is  placed  upon  importers  trading  with  other  countries 
than  England.  Normally,  as  has  been  shown  in  another 
place,  ^  the  exchange  rates  of  all  countries  are  brought  into 
harmony  with  each  other  through  the  equalizing  effects  of 
arbitrage.  The  premium  on  sterling  exchange,  if  prolonged 
and  increased  by  a  gold  embargo,  will  react  upon  the  other 
rates,  causing  them,  also,  to  rise  with  the  result  that  all  im- 
porters are  penalized  when  buying  sight  drafts  to  pay  debts 
already  contracted.  Bills  of  exchange  are,  on  the  whole,  a 
most  economical  and  cost-saving  device;  but  they  are  not 
always  cheaper  than  other  modes  of  payment,  and  to  force 
Iheu"  use  upon  a  country  when  they  have  ceased  to  be  less 
expensive  than  the  shipping  of  gold  is  tantamount  to  taxing, 
ex  post  facto,  all  individuals  within  the  country  who  have  con- 
tracted foreign  obligations. 

In  the  second  place,  free  movement  of  gold  between  the 
nations  is  a  normal  and  healthful  method  of  bringing  inter- 
national commerce  into  equilibrium.  The  exchange  rates 
would  not  rise  to  the  specie  point  if  the  nation  paid  in  goods 
and  services,  or  gave  satisfactory  promises  to  pay  at  a  later 
date,  for  the  things  she  buys  of  other  peoples.  Only  when  the 
nation  buys  more  than  she  pays  for,  and  gives  no  acceptable 
promises  to  pay  the  balance,  will  she  be  called  upon  to  export 
gold.  But  this  is  not  a  healthful  condition  and  it  cannot  con- 
^  See  pages  97  f. 


THE  RATES  OF  EXCHANGE  125 

tinue;  its  correction  demands  that  the  nation  reduce  its  pur- 
chases within  the  measure  of  its  abiUty  to  pay,  and  the  free 
movement  of  gold  will  work  out  this  correction  by  a  natural 
and  painless  process. 

Goods  are  imported  only  when  their  prices  are  so  much 
lower  abroad  that  they  can  bear  the  cost  of  transportation 
and  still  compete  with  domestic  goods  in  the  importing  mar- 
ket. If  a  country  is  importing  more  than  it  should  —  that 
is,  more  than  it  can  make  payment  for  —  the  most  effective 
solution  is  to  remove  the  incentive  to  import  by  diminishing 
the  discrepancy  between  foreign  and  domestic  prices.  One 
basic  factor  determining  the  general  price  levels  of  the  dif- 
ferent countries  is  their  supply  of  primary  money  —  that  is, 
for  gold  standard  countries,  the  stock  of  gold  bullion  and  coin. 
As  the  stock  of  gold  increases,  credit  expands  and  the  general 
price  level  rises;  as  the  stock  of  gold  decreases,  credit  con- 
tracts and  the  price  level  falls.  Hence,  when  gold  is  shipped 
from  one  nation  to  another  in  considerable  quantities,  the 
average  of  prices  in  the  former  will  begin  to  fall;  in  the  latter, 
to  rise.  As  a  consequence,  individuals  within  the  country 
which  is  losing  gold  will  gradually  lose  their  incentive  to 
import,  as  domestic  prices  cease  to  be  higher  than  foreign 
prices.  This  process  will,  of  course,  not  affect  all  goods  in  the 
same  degree,  nor  will  it  work  out  its  effect  suddenly  or  in  a 
manner  to  subject  the  industrial  structures  of  the  nations 
concerned  to  an  arbitrary  disturbance.  But  its  effects  will 
be  far-reaching,  and  they  will  be  permanent  until  some  new 
factor  enters  to  disturb  again  the  equilibrium  of  trade; 
whereas  if  gold  is  prevented  from  leaving  the  country  when 
the  balance  of  trade  is  unfavorable,  and  the  consequent  rise 
of  the  rates  of  exchange  brings  about  a  reduction  of  imports 
by  reason  of  its  burden  upon  the  import  trade,  the  situation 
will  remain  distorted,  since  the  price  levels  of  the  two  coun- 
tries will  not  have  been  brought  into  adjustment  with  each 
other. 

This  effect  of  the  gold  movement  upon  the  relative  price 
levels  of  the  nations  makes  it  clear  that  much  of  the  opposi- 
tion to  the  exportation  of  gold  is  unfounded.     The  fear  that 


126  FOREIGN  EXCHANGE 

the  monetary  stock  of  the  country  will  be  completely  ex- 
hausted, or  even  seriously  impaired,  when  the  balance  of 
trade  is  unfavorable,  has  no  basis  in  fact;  for  the  outflow  of 
gold  is  self-limiting.  It  cannot  continue  longer  than  its 
cause  —  the  discrepancy  between  foreign  and  domestic 
prices  which  induces  an  excessive  importation  of  foreign 
goods;  by  removing  the  cause  of  the  unbalanced  trade,  the 
outflow  of  gold  brings  itself  to  an  end  without  the  interference 
of  governments,  and  this  natural  limit  to  the  loss  of  gold  will 
be  reached  before  the  country  can  suffer  any  ill-effects  from 
the  lessening  of  its  money  supply.  These  statements  are 
made,  of  course,  only  with  reference  to  normal  conditions;  in 
times  of  war  or  financial  panic,  the  conserving  of  the  gold 
stock  may  be  an  unavoidable  necessity  regardless  of  the 
detrimental  effects  of  the  policy. 

34.  Pegging  the  rate  of  exchange.  Occasions  may  arise 
when  a  country  is  unwilling  or  unable  either  to  export  gold  or 
to  reduce  its  importations  of  foreign  goods,  although  its  bills 
are  quoted  at  low  rates  in  foreign  markets.  This  has  been  the 
condition  of  certain  European  countries  with  respect  to  their 
trade  %dth  the  United  States  following  the  Great  War.  Bur- 
dened with  heavy  exchange  charges  when  making  payment 
for  American  goods,  the  importers  in  these  countries  have,  in 
numerous  instances,  found  it  impossible  to  continue  their 
business;  national  interest,  on  the  other  hand,  has  demanded 
that  the  trade  be  kept  alive  at  all  costs,  since  there  was  no 
other  market  from  which  supplies  of  essential  materials  could 
be  obtained.  In  view  of  this  state  of  national  necessity  and 
of  the  absence  of  the  normal  correctives  of  the  exchange 
market,  it  has  been  proposed  to  stabilize  the  exchange  rates 
in  New  York  by  artificial  means,  fixing  a  definite  point  below 
which  they  will  not  be  allowed  to  fall.  This  arbitrary  limita- 
tion on  the  fluctuations  of  the  exchange  market  is  called 
pegging  the  rates  of  exchange. 

Before  proceeding  to  examine  the  method  and  effects  of 
pegging  the  rates,  it  may  be  well  to  call  attention  to  the  fact 
that  the  motive  behind  the  policy  is  largely  drawn  from  a 
misconception   of   the   forces  which   govern  the  exchange 


THE  RATES  OF  EXCHANGE  127 

markets.  When  the  rates  of  exchange  on  a  nation's  bills  are 
unfavorable,  the  belief  spreads  that  foreign  bankers  and 
business  men  have  deliberately  manipulated  the  exchange 
market  with  the  intention  of  reaping  exorbitant  profits  from 
the  necessities  of  the  importing  country.  This  view  is,  of 
course,  totally  without  foundation  in  fact.  Abnormally  low 
rates  on  foreign  bills  in  New  York,  for  example,  are  not  a 
source  of  profit,  but  a  burden  and  a  handicap  to  the  business 
men  and  bankers  of  the  United  States.  Moreover,  these 
quotations  are  caused,  not  by  the  business  interests  of  this 
country,  but  by  the  action  of  foreign  importers  whose  com- 
petition for  credits  in  New  York  causes  the  dollar  rates  to  rise 
to  excessive  premiums  abroad  and  the  foreign  rates  to  fall  to 
excessive  discounts  here.  No  country  is  benefited  by  an  ab- 
normal condition  of  the  exchange  market.  However,  the 
common  belief  that  they  are  being  exploited  when  exchange 
rates  are  unfavorable  frequently  impels  the  people  of  a  coun- 
try to  adopt  artificial  means  of  removing  the  handicap  to  their 
trade. 

The  attempt  to  peg  the  rate  of  exchange  relies  for  its 
efiFectiveness  upon  providing  an  offset  for  the  force  which  is 
causing  the  rate  to  fall.  This  force  is  an  excessive  supply 
of  bills  drawn  against  the  country  and  offered  for  sale  by 
foreign  exporters;  the  rate  can  be  prevented  from  falling  only 
by  creating  a  large  enough  demand  for  these  bills  to  absorb 
the  entire  supply  at  a  given  rate.  For  example,  when  the 
sterling  rate  was  pegged  in  New  York  during  the  final  years 
of  the  Great  War,  England  undertook  to  buy  all  sterling 
bills  offered  for  sale  in  New  York  at  a  uniform  price  of  4.76. 
The  unlimited  demand  for  sterling  at  that  rate  prevented  the 
purchase  of  sterling  bills  on  lower  terms  by  any  other  agency 
in  New  York,  since  the  holders  of  these  bills  would  not 
knowingly  dispose  of  them  for  less  than  the  highest  available 
price.  The  device  did  not,  of  itself,  prevent  the  rate  from 
rising  above  4.76;  but  the  supply  of  bills  drawn  on  England 
was  so  great  during  this  period,  and  the  demand  from  the 
commercial  world  so  small,  that  there  was  no  impulse  to  raise 
the  rate  above  this  minimum.      While  the  policy  was  in 


128  FOREIGN  EXCHANGE 

ppornlion,  therefore,  sterlincj  remained  at  a  fixed  quotation, 
and  Urilisli  inijiorlcrs  were  relieved  from  the  burden  of  an 
extreme  diseount  on  sterling  bills  \vhieh  would  undoul)tedly 
have  developed  if  the  market  had  been  subjected  to  the  free 
play  of  competitive  forces. 

The  i)oliey  of  pegging  the  rate  of  exchange  relies  upon  a 
demand  for  bills  which  is  abnormal  in  the  sense  that  it  does 
not  arise  from  international  commerce,  but  must  be  created 
for  the  express  purpose  of  absorbing  the  supply  of  bills  having 
a  commercial  origin.  To  create  the  funds  with  which  to  buy 
these  bills,  an  indefinite  credit  must  first  be  established  within 
the  market  where  the  exchange  rate  is  to  be  pegged.  The 
British  Government  created  this  credit  by  borrowing  from 
the  Treasury  of  the  United  States,  placing  the  funds  obtained 
in  this  manner  in  the  hands  of  bankers  in  New  York  to  be 
used  for  the  purchase  of  sterling  bills.  Any  attempt  to  peg 
the  rate' of  exchange  must  proceed  upon  similar  lines;  es- 
sentially, the  process  consists  in  inducing  one  group  of  citizens 
within  the  country  (the  group  which  lends  the  funds  used  to 
peg  the  rate)  to  pay  a  second  group  of  citizens  for  goods 
supplied  to  a  foreign  people,  on  the  promise  of  a  return  of  the 
funds  thus  advanced  at  a  later  date.  The  policy  will  be 
effective  in  stabilizing  the  rate  of  exchange  so  long  as  a  suflB- 
cient  amount  of  funds  can  be  borrowed  within  the  market 
itself  to  absorb  all  bills  offered  for  sale  there.  There  are 
weighty  reasons  why  such  an  interference  with  the  exchange 
market  is  undesirable  and  injurious. 

At  best  the  attempt  to  prevent  the  rate  from  falling  can  be 
efifective  only  as  a  temporary  policy.  Eventually,  the  funds 
borrowed  by  the  nation  for  the  purpose  of  buying  its  own 
bills  of  exchange  must  be  repaid  with  interest;  for  it  is  incon- 
ceivable that  any  group  of  people  will  continue  indefinitely 
to  supply  goods  to  a  foreign  country  and  bear  their  cost  them- 
selves. If  the  loans  are  refunded  as  they  fall  due,  and  new 
loans  are  contracted  to  continue  the  policy,  this  will  only  post- 
pone the  time  of  repayment  and  increase  the  amount  to  be 
paid;  eventually  the  sheer  impossibility  of  obtaining  credit 
within  the  market  for  this  purpose  must  bring  the  policy  to 


THE  RATES  OF  EXCHANGE  129 

an  end.  But  when  the  repayment  of  the  loans  commences, 
the  force  depressing  the  rate  of  exchange  will  be  increased  in 
magnitude;  for  the  repayment  of  a  loan  by  one  country  to 
another  creates  in  the  creditor  market  a  supply  of  bills  drawn 
on  the  debtor.  This  supply  of  bills  will  be  added  to  the  sup- 
ply drawn  by  the  exporters  of  goods  and  so  will  increase  the 
pressure  on  the  rate  of  exchange.  If  the  original  cause  — 
that  is,  an  unbalanced  commerce  —  is  still  operative,  the 
policy  of  pegging  the  rate  will  only  have  made  matters  worse; 
for  now  the  excess  supply  of  bills  will  be  larger  than  ever  and 
the  rate  must  fall  still  farther  to  take  them  off  the  market. 
Only  in  the  event  that  the  balance  of  payment  has  shifted  in 
the  meantime,  and  the  country  which  has  been  buying  its 
own  bills  now  finds  that  the  commercial  demand  is  large 
enough  to  absorb  the  supply,  can  the  device  fail  to  aggravate 
the  evil  which  it  aims  to  correct. 

This  brings  us  to  a  second,  and  more  serious,  objection  to 
the  device  of  pegging  the  rate  of  exchange:  the  policy  exerts 
an  influence  upon  international  trade  which  tends  to  perpetu- 
ate a  distorted  and  unbalanced  state  of  commerce.  If  ster- 
ling, or  other  foreign  rates  are  falling  in  the  New  York  market, 
the  only  permanent  solution  of  the  problem  is  for  the  coun- 
tries in  question  to  diminish  their  imports  of  American  goods 
and  increase  their  exports  to  America.  But  to  maintain  the 
rates  at  a  high  point  removes  all  penalty  on  the  importation 
of  goods  from  the  United  States,  and  all  encouragement  to 
increase  exports  to  this  country.  Hence,  the  unbalanced 
state  of  commerce  is  likely  to  continue  or  even  to  grow  more 
extreme;  industries  both  here  and  abroad  will  become  ad- 
justed to  the  existing  volume  of  exports  and  imports,  so  that 
when  the  policy  of  pegging  the  rates  ends  —  and  end  it  must 
from  sheer  impossibility  of  continuing  it  indefinitely  —  the 
resulting  collapse  of  the  exchange  market  will  be  at  the  same 
time  more  extreme  and  more  disastrous  in  its  effects  than  if 
the  readjustment  had  proceeded  gradually  under  the  pressure 
of  a  slowly  falling  rate  of  exchange. 


CHAPTER  VI 

BANKERS'  BILLS  OF  EXCHANGE 

35.  Bankers'  demand  drafts  and  cables.  Generally  speak- 
ing, international  transactions  are  liquidated  in  either  of  two 
ways:  by  a  bill  of  exchange  drawn  by  the  creditor;  or  by  a 
remittance  of  a  bill  of  exchange  by  the  debtor.  In  the  chap- 
ters immediately  following,  we  shall  examine  the  different 
forms  of  bills  which  arise  from  international  commercial  trans- 
actions when  the  creditor  draws;  it  is  our  present  purpose  to 
discuss  the  practice  of  the  exchange  markets  in  those  cases 
where  the  terms  of  sale  place  upon  the  buyer  the  obligation 
of  remitting  payment  to  the  seller.  Such  terms,  though  com- 
mon in  the  dealings  of  American  exporters  with  certain  mar- 
kets, have  been,  on  the  whole,  the  exception  to  the  rule  in 
international  trade.  They  result,  for  the  most  part,  from 
cash  sales  —  that  is,  sales  which  require  cash  payment  from 
the  buyer  either  in  advance  of,  or  upon,  delivery  of  the  goods 
—  or  from  sales  on  open  book  account,  where  the  buyer  is 
instructed  to  cancel  his  debt  at  the  end  of  a  predetermined 
period  by  a  remittance  of  cash.  As  used  in  foreign  trade, 
cash  terms  do  not,  of  course,  signify  the  remittance  of  gold  or 
other  money,  but  rather  the  remittance  of  an  instrument 
which  can  be  turned  into  money  without  delay  by  the  credi- 
tor. The  instrument  used  for  this  purpose  is  most  com- 
monly the  bankers'  demand  draft,  or  check;  though  in  rare 
cases,  when  time  must  be  saved,  the  cable  is  employed. 

The  demand  draft  and  the  cable  (often  called  the  tele- 
graphic transfer)  have  been  described  at  various  points  in  the 
preceding  pages;  our  present  purpose  will  be  to  gather  this 
information  together,  and  to  illustrate  the  practical  use  made 
of  these  instruments  by  the  business  world.  Let  us  assume, 
then,  that  an  importer  of  American  goods  in  Argentina  is 
under  the  necessity  of  sending  one  thousand  dollars  in  cash 


BANKERS'  BILLS  OF  EXCHANGE  131 

to  his  creditor  in  New  York  in  payment  of  an  account  falling 
due  on  the  creditor's  books.  The  importer  will  go  to  his 
banker  and  buy  for  pesos  a  demand  draft  for  this  amount 
drawn  on  a  banker  in  New  York,  payable  to  himself,  or  his 
order.  Properly  endorsed,  this  draft  will  be  sent  by  mail  to 
the  exporter  in  America,  who  will  deposit  it  at  his  bank;  it 
will  be  presented  to  the  drawee-banker  for  payment,  and,  a 
few  hours  after  its  arrival,  the  exporter's  bank  account  will 
have  been  increased  by  the  amount  of  the  draft.  From  the 
point  of  view  of  the  exporter,  this  mode  of  payment  is  no  less 
convenient  than  the  receipt  of  checks  from  his  domestic  cus- 
tomers ;  for  the  importer,  it  is  more  convenient  than  the  ship- 
ment of  gold,  or  other  money;  both  business  men  deal  with 
their  own  bankers  and  in  their  own  currency.  To  create  and 
maintain  the  balance  in  New  York  which  allows  the  South 
American  banker  to  draw  a  demand  draft  payable  in  that  city 
in  dollars  requires  that  the  drawing  banker  remit  to  his  New 
York  correspondent  a  stream  of  collection  and  discount  items 
—  bills  of  exchange  of  various  kinds  —  which  will  cause  an 
inflow  of  funds  to  the  correspondent  banker.  This  two-sided 
transaction,  the  buying  of  miscellaneous  bills  from  his  clients 
payable  in  foreign  centers,  and  the  sale  of  his  own  demand 
drafts  against  his  foreign  credits,  constitutes  the  principal 
business  of  the  exchange  banker. 

The  cable,  or  telegraphic  transfer,  is  a  demand  draft  sent 
by  cable  instead  of  by  mail.  Its  effect  upon  the  banker's 
foreign  balance  is  more  immediate  and  this  difference  causes 
a  variation  in  the  rates  at  which  the  banker  will  sell  the  two 
forms  of  exchange.  ^  The  cable  is  used  in  international  com- 
merce for  transmitting  funds  when  the  saving  of  time  is  a 
significant  factor  in  the  profitableness  of  the  transaction. 
In  business  transactions,  its  chief  service  consists  in  enabling 
the  debtor  to  postpone  his  remittance  for  a  number  of  days 
and,  thereby,  to  extend  the  credit  period  within  which  he  is 
allowed  to  prepare  for  payment. 

To  illustrate  with  reference  to  the  example  employed  above, 

*  See  pages  84  f.,  where  the  relation  of  the  cable  to  the  sighc  rate  is 
explained. 


132  FOREIGN  EXCHANGE 

lot  us  assume  tliat  the  Argentine  importer  is  under  obligation 
to  place  his  remittance  in  the  hands  of  the  New  York  exporter 
on  July  1st,  The  mail  time  between  Buenos  Aires  and  New 
York  we  may  suppose  to  be  thirty  days;  hence,  to  discharge 
his  obligation  by  remitting  a  demand  draft,  the  Argentine 
merchant  must  expend  his  pesos  in  the  purchase  of  the  draft 
on  June  1st.  But  by  using  the  cable,  he  can  postpone  remit- 
tance until  two  days  before  his  creditor  must  receive  his 
money,  thus  obtaining  an  extension  of  credit  for  twenty-eight 
days.  The  telegraphic  transfer  will  cost  more  than  the 
demand  draft,  of  course,  and  the  service  charge  for  using  the 
cable  will  add  still  another  item  to  the  importer's  expense. 
Nevertheless,  conditions  in  the  importer's  market  may  be 
such  as  to  make  this  additional  cost  worth  while.  He  may 
not  have  been  able  to  dispose  of  the  goods  which  he  has  im- 
ported, but  expects  a  better  market  in  a  short  time;  or,  he 
may  be  pressed  for  funds  and  finds  it  cheaper  to  gain  twenty- 
eight  days'  extension  at  the  cost  of  using  the  cable  than  to 
borrow  from  his  bank;  or,  the  rates  of  exchange  may  be  ad- 
verse on  June  1st  and  he  expects  rates  to  be  sufficiently  lower 
later  on  to  make  postponement  worth  while.  The  cable  is 
more  frequently  used  to  postpone  payment  in  international 
transactions  other  than  commercial.  Bankers  who  have 
borrowed  in  a  foreign  market  may  find,  as  the  date  for  repsiy- 
ment  approaches,  that  their  funds  are  so  well  employed  as 
to  make  it  worth  while  to  gain  a  few  days  by  remitting  cable 
transfers  instead  of  checks.  Speculators  who  have  sold  long 
exchange,  expecting  to  cover  later  at  lower  rates,  may  use  the 
cable  to  postpone  payment  for  a  few  days  when  rates  are 
falling.  These  transactions  between  the  bankers  of  different 
exchange  centers  will  be  explained  at  greater  length  at  a  later 
point  in  our  study. 

Further  information  concerning  the  bank's  methods  of 
handling  demand  drafts  and  telegraphic  transfers  may  be 
obtained  by  examining  the  copies  given  on  pages  134-35, 
of  the  forms  used  by  the  largest  New  York  bank  when  selling 
these  bills  to  their  clients. 

The  first  of  these,  an  order  for  a  cable  transfer  by  the  client 


BANKERS'  BILLS  OF  EXCHANGE  133 

of  the  bank,  shows  that  in  the  case  of  this  type  of  exchange  it 
is  the  bank  which  actually  makes  the  remittance,  and  not  the 
buyer  of  the  cable.  The  latter  fills  out  the  blank,  giving  the 
name  of  the  foreign  drawee  and  the  amount  to  be  sent  stated 
in  the  foreign  currency;  this  amount  is  turned  into  dollars  at 
the  cable  rate  of  exchange,  the  cost  of  sending  the  message 
over  the  wire  is  then  added,  and  the  total  is  paid  by  the  client 
of  the  bank.  The  bank  then  undertakes  to  transmit  the  mes- 
sage in  the  form  of  the  telegram  to  the  drawee,  giving  him  an 
order  drawn  payable  on  demand  upon  the  bank's  corre- 
spondent. The  banker's  demand  draft,  as  shown  by  the 
second  form,  is  filled  out  by  some  one  in  the  foreign  depart- 
ment of  the  bank,  signed  by  the  appropriate  oSicer  and 
delivered  to  the  client  to  be  sent  by  mail  to  the  foreign  drawee. 
Attention  is  called  to  the  inserted  paragraphs  which  these 
forms  contain.  The  first  of  these  paragraphs,  which  appears 
upon  the  order  for  a  cable  transfer,  shows  that  the  bank, 
while  accepting  payment  from  the  client  in  advance,  specif- 
ically waives  all  liability  for  errors  or  failure  to  transmit  on 
the  part  of  the  cable  company;  all  such  risks  are  to  be  borne 
by  the  bank's  client.  The  second  paragraph,  which  also 
appears  in  substantially  the  same  form  upon  the  application 
for  a  banker's  draft,  contains  information  of  some  importance 
to  the  client.  This  paragraph,  in  the  first  place,  emphasizes 
the  fact  that  the  bank's  rule  when  dealing  in  foreign  exchange 
is  one  of  compensating  purchase  and  sale;  that  is,  "exchange 
will  be  promptly  purchased  to  cover  this  remittance." 
Because  of  this  practice,  the  bank  refuses  to  be  held  liable, 
in  case  payment  is  not  made  abroad,  "for  any  amount  in  ex- 
cess of  the  value  in  New  York  of  such  exchange  at  the  time 
refund  is  made."  In  other  words,  the  client  is  not  to  expect 
a  refund  of  the  amount  of  money  paid  by  him  when  the  bill 
was  purchased,  but  of  the  value  at  that  time  of  the  cover 
bought  by  the  bank;  hence,  the  refund  may  be  less  than  the 
amount  paid  by  the  client.  The  effect  of  this  clause  is  ob- 
viously to  throw  upon  the  client,  not  only  the  risk  of  incon- 
venience due  to  failure  of  payment  abroad,  but  also  risk  of 
loss  through  decline  in  the  rates  of  exchange  in  the  period 


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FOREIGN  EXCHANGE 


wliich  elapses  between  the  purchase  of  the  bill  and  the  refund 
by  the  bank.  From  the  standpoint  of  the  bank,  this  practice 
is  defended  by  the  following  reasoning:  the  bank  has  bought 

Form  6.  Banker's  Sterunq  Demand  Draft 

Forelfrn  drafts  of  all  kinds  are  invariably  drawn  in  duplicate  or  triplicate.  The  "original" 
is  sent  by  one  mail,  and  the  "duplicate"  by  the  following  mail,  to  guard  against  the  risk  of 
loss  in  transit    The  third  copy,  if  drawn,  is  retained  as  a  record  of  the  transaction. 


cover  for  a  remittance  made  for  the  benefit  of  the  client;  in 
case  payment  abroad  is  not  made,  this  cover  will  remain  with 
the  foreign  correspondent  where  it  will  have  a  value  deter- 


BANKERS'  BILLS  OF  EXCHANGE  137 

mined  by  the  rate  of  exchange;  thus,  if  a  refund  is  made,  the 
bank  should  not  be  made  to  lose  because  of  shrinkage  in  the 
value  of  the  cover.  ^ 

Bankers'  demand  drafts  command  the  widest  and  most 
competitive  market  of  all  forms  of  exchange,  and  their  prices 
respond  most  readily  to  the  fluctuations  of  demand  and  sup- 
ply. Not  only  are  these  drafts  bought  by  business  men  for 
payments  due  to  foreign  creditors,  but  bankers  and  other 
exchange  dealers  regularly  buy  and  sell  them  among  them- 
selves. Each  banker  keeps  close  watch  upon  his  foreign 
balance,  striving  to  maintain  a  sufficient  credit  to  meet  all  the 
drafts  he  might  wish  to  make,  and,  at  the  same  time,  to  avoid 
loss  due  to  idle  funds  in  a  foreign  city.  This  proportioning 
of  the  size  of  his  foreign  balance  to  the  uses  to  which  it  can  be 
put  is  accomplished  by  maintaining  a  rough  equality  from  day 
to  day  between  the  debits  and  credits  to  his  account  with  the 
foreign  correspondent,  so  that  a  stable  average  credit  may  be 
available  at  all  times.  But  if  governed  only  by  his  relations 
with  his  clients,  the  accretions  to  the  banker's  foreign  balance, 
and  the  debits  against  it,  can  scarcely  be  uniform  from  day  to 
day;  for  the  bills  he  buys  for  remittance  will  vary  in  length 
of  life  and  in  amount  according  to  the  nature  of  his  clients' 
transactions,  and  the  demand  for  his  own  checks  and  cables 
^all  fluctuate  with  the  needs  of  the  business  world.  To  offset 
these  variations,  the  banker  will  buy  demand  drafts  in  the 
open  market  when  his  foreign  balance  must  be  replenished, 
and  offer  his  own  drafts  for  sale  when  the  credit  has  grown  to 
undue  proportions.  When  engaged  in  this  manner  in  off- 
setting his  transactions  with  business  men  by  operations  in 
the  open  market,  it  is  obvious  that  the  terms  offered  by  the 
banker  to  his  customers  will  be  conditioned  upon  the  rates 
which  he  himself  must  give  or  take  in  the  open  market.  That 
is,  the  banker's  buying  price  for  commercial  bills  will  be  de- 
rived from  the  open  market  sight  rate  of  exchange;  his  profit 
will  be  drawn  from  a  slight  difference  in  his  favor  between  the 
rates  of  exchange  at  which  he  buys  and  sells. 

^  This  practice  has  developed  because  of  unsettled  coQditions  which  have 
foUowed  the  Great  War:  it  may  not  be  permanent. 


138  FOREIGN  EXCHANGE 

Without  raising  accain  the  problem  of  the  rates  of  exchange, 
it  may  he  in  ])oint  at  this  phicc  to  note  that  the  same  forces 
which  cause  the  balance  of  an  individual  banker  to  swell  be- 
yond the  point  of  profit,  will,  at  the  same  time,  in  all  proba- 
bility, operate  in  the  same  way  upon  other  exchange  bankers 
of  his  market.  For  the  offerings  of  commercial  bills  to  the 
banks  in  New  York  are  controlled  fundamentally  by  the  vol- 
ume of  exports  from  this  country  to  foreign  markets,  and  are, 
therefore,  subject  to  the  seasonal  ebb  and  flow  of  our  com- 
merce. So  it  comes  about  that  many  bankers  are  at  the 
same  time  anxious  to  sell  their  demand  drafts  in  the  open  mar- 
ket, while  few  are  in  a  position  to  buy  them  profitably,  and 
competition  among  the  sellers  depresses  the  rate  of  exchange 
toward  the  specie  importing  point.  On  the  other  hand,  the 
demand  for  drafts  with  which  to  pay  for  our  imports  will 
probably  exhaust  the  foreign  credits  of  many  bankers  at 
the  same  time,  forcing  them  into  the  market  as  buyers  of  bills 
of  exchange,  and  thus  driving  the  rates  upward  toward  the 
specie  exporting  point.  For  these  reasons,  the  open  market 
quotation  on  bankers'  demand  drafts  is  a  sensitive  index  to  the 
total  demand  and  supply  of  bills  of  exchange,  and,  more  fun- 
damentally, to  the  ebb  and  flow  of  international  commerce. 

This  matter  of  the  fluctuations  in  the  rates  of  exchange 
raises  the  question  as  to  the  effect  of  these  fluctuations  upon 
the  profits  of  business  men  whose  undertakings  require  them 
to  make  or  receive  remittances  of  foreign  demand  drafts. 
Returning  to  our  illustration  from  the  typical  transaction 
between  a  New  York  and  an  Argentine  merchant,  we  call 
attention  to  the  fact  that  the  Argentine  importer  was  com- 
pelled to  bear  the  cost  of  changing  one  kind  of  money  into 
another;  that  is  to  say,  it  fell  to  his  lot  to  expend  pesos  in  the 
purchase  of  a  dollar  demand  draft.  The  American  exporter, 
who  had  sold  goods  worth  $1000,  received  his  payment  in 
dollars;  for  him,  the  transaction  was  in  no  wise  affected  by  the 
position  of  the  rate  of  exchange  between  New  York  and  Ar- 
gentina. But  this  matter  of  the  rate  of  exchange  was  of  some 
importance  to  the  importer,  since  it  had  the  power  to  affect 
the  profitableness  of  the  transaction.    At  par,  the  dollar  draft 


BANKERS'  BILLS  OF  EXCHANGE  139 

for  $1000  would  cost  him  2356  pesos  (par  between  Argentina 
and  New  York  is  $42.44  =  100  pesos).  If,  however,  he  had 
bought  the  draft  on  March  11,  1921,  when  the  dollar  com- 
manded a  premium  of  18.4  per  cent  in  Argentina,  its  cost 
would  have  been  2789.50  pesos;  three  months  later,  on  June 
10th,  the  same  draft  would  have  cost  2975.62  pesos,  because 
the  premium  on  the  dollar  had  in  the  meantime  risen  to  26.3 
per  cent.  Now,  the  Argentine  importer,  obviously,  cannot 
know  how  much  he  has  paid  for  the  goods  until  the  dollar 
draft  has  been  bought,  nor  can  he  safely  price  them  for  sale 
in  his  own  market  until  he  knows  what  they  have  cost.  Con- 
sulting the  exchange  rate  on  the  day  the  goods  arrive  will  not 
avail  to  solve  his  problem,  if  the  rate  is  subject  to  sudden  and 
violent  fluctuations  such  as  that  illustrated  in  the  two  quo- 
tations given  above  for  March  11th  and  June  10th,  1921,  re- 
spectively. This  danger  of  loss  through  adverse  changes  in 
the  rates  is  called  risk  of  exchange.  It  is  borne  by  all  mer- 
chants whose  costs  or  receipts  are  conditioned  upon  the  posi- 
tion of  a  rate  of  exchange  upon  some  future  date,  after  they 
have  made  commitments  in  international  transactions. 

From  what  has  just  been  said  concerning  the  risk  of  ex- 
change, it  will  be  readily  understood  that  importers  who  ob- 
ligate themselves  to  make  future  remittances  of  demand 
drafts  are  concerned  that  the  type  of  draft  agreed  upon  shall 
be  one  whose  rate  of  exchange  is  relatively  stable.  The  ex- 
ample given  above  is,  of  course,  abnormal,  since  it  was  chosen 
from  a  time  when  the  foreign  exchange  markets  of  the  world 
were  greatly  disturbed  by  post-war  condiLions.  But  even  in 
normal  times  these  fluctuations  in  the  sight  rates  occur,  and 
their  violence  varies  greatly  among  bills  drawn  in  different 
moneys.  As  explained  in  another  place,  ^  these  changes  in 
the  banker's  drawing  rate  for  demand  drafts  on  foreign  cities 
are  caused  by  changes  in  the  condition  of  the  banker's  balance 
in  those  cities  in  relation  to  the  demands  made  upon  him  to 
draw  against  these  balances.  They  are  least  likely  to  occur 
with  respect  to  demand  drafts  drawn  on  foreign  centers  where 
the  banker's  foreign  balance  is  maintained  in  a  relatively 
^  See  pages  61  f. 


140  FOREIGN  EXCHANGE 

slal)lc  condition  l^cciiiise  of  llie  fact  thai,  in  his  own  market, 
there  is  a  broad  and  continuous  demand  for  his  drafts  and  an 
equally  broad  and  continuous  supply  of  the  bills  of  his  clients 
payable  in  that  city.  They  are  most  likely  to  occur  with  re- 
spect to  demand  drafts  drawn  on  out-of-the-way  places  where 
the  banker's  balance  fluctuates  widely  because  the  debits  and 
credits  which  he  makes  to  it  are  discontinuous  and  erratic. 
Business  men  engaged  in  foreign  trade  learn  from  experience 
what  kinds  of  bills  are  most  easily  procured  and  command  the 
most  stable  rates  of  exchange,  and,  by  common  consent,  they 
employ  these  bills  much  more  widely  than  any  others.  It  is 
for  this  reason  among  others  that  sterling  drafts  have  been 
used  in  the  past  in  preference  to  dollar  drafts,  even  to  dis- 
charge remittances  to  the  United  States;  though  the  broader 
market  for  dollar  bills  which  has  developed  in  most  foreign 
centers  since  the  Great  War  is  somewhat  qualifying  the  older 
practice.  We  need  not  stress  the  fact  that  when  the  remit- 
tance draft  is  dra^Ti  in  a  third  money  —  foreign  to  both  im- 
porter and  exporter  —  as  in  remittances  of  sterling  sight 
drafts  from  South  America  to  the  United  States  —  both 
parties  must  bear  a  risk  of  exchange,  since  the  costs  of  the  im- 
porter and  the  receipts  of  the  exporter  are  both  dependent 
upon  the  position  of  the  sterling  sight  rate  in  their  markets  at 
a  future  date. 

Thus  far  in  our  discussion,  it  has  been  assumed  that  de- 
mand drafts  and  cables  are  drawn  against  foreign  balances 
maintained  by  the  drawing  bankers  with  their  correspondents. 
But  if  the  maintenance  of  a  foreign  balance  were  the  sole  con- 
dition upon  which  these  drafts  could  be  drawn,  very  few 
bankers  in  any  country  could  supply  them  to  their  clients, 
since  the  majority  of  bankers  —  especially  those  at  inland 
points  —  never  carry  a  foreign  balance.  Moreover,  even 
those  larger  banking  houses  which  engage  actively  in  the 
business  of  foreign  exchange  would  frequently  be  unable  to 
draw  drafts  at  the  request  of  their  clients,  since  they  cannot 
attempt  to  carry  balances  in  every  one  of  the  foreign  centers 
in  which  business  men  might  have  need  of  funds.  Yet  we 
know  that  inland  bankers  who  have  no  foreign  balances  do 


BANKERS'  BILLS  OF  EXCHANGE  HI 

draw  demand  drafts  in  favor  of  the  business  men  in  their 
markets,  and  that  exchange  bankers  at  the  seaboard  are  rarely 
at  a  loss  to  provide  these  drafts  no  matter  where  they  are 
payable.  We  shall  now  consider  the  means  customarily 
employed  to  enable  a  banker  to  draw  against  a  foreign  bank 
with  which  the  drawing  banker  carries  no  balance. 

With  regard  to  the  inland  banks,  the  procedure  is  somewhat 
as  follows:  The  large  banks  in  New  York  offer  a  service  to 
these  inland  banks,  the  purpose  of  which  is  to  enable  the  in- 
land bankers  to  draw  checks  against  any  of  the  foreign  bal- 
ances of  the  New  York  banker.  The  conditions  on  which  the 
service  is  offered  are  that  the  inland  bank  maintain  a  deposit 
with  the  New  York  bank  proportioned  to  the  average  amount 
of  the  inland  bank's  drawings,  and  agree  to  a  certain  schedule 
of  commission  charges.  The  drafts  are  drawn  on  a  form  of  a 
peculiar  kind  —  peculiar  in  color,  shape,  or  wording  —  sup- 
plied by  the  New  York  bank;  this  distinctive  appearance 
serves  to  identify  the  drafts  to  the  foreign  correspondents  of 
the  New  York  bank,  who,  of  course,  are  apprised  in  advance 
of  the  permission  extended  the  inland  bank  to  draw  against 
another  banker's  balance.  They  are  paid  by  the  foreign  cor- 
respondent out  of  the  New  York  bank's  balance,  and  the  lat- 
ter recoups  itself  by  charging  the  appropriate  amount  against 
the  deposit  which  the  inland  bank  maintains  in  New  York. 

A  typical  transaction  liquidated  by  this  method  would  be 
carried  through  as  follows:  Suppose  a  dealer  in  china-ware 
situated  in  Des  Moines,  Iowa,  is  under  obligation  to  remit  to 
England  a  demand  draft  for  one  thousand  pounds  sterling  in 
payment  for  goods  imported.  His  banker  in  Des  Moines, 
though  he  carries  no  balance  in  London,  has  engaged  the  serv- 
ices of  a  New  York  banker  who  does  have  a  London  balance, 
carrying  the  requisite  deposit  with  the  New  York  banker  for 
this  purpose.  The  china-ware  merchant  requests  a  sterling 
demand  draft  of  one  thousand  pounds;  the  Des  Moines 
banker  draws  it  directly  against  a  London  bank  on  the  appro- 
priate form,  gives  it  to  the  merchant,  and  informs  the  New 
York  bank  of  the  transaction.  The  New  York  banker  im- 
mediately sends  advice  to  London  sanctioning  the  draft  and 


14?  FOREIGN  EXCHANGE 

requestinfr  that  it  be  pcaid  out  of  his  balance.  By  the  time  the 
draft,  which  lias  been  mailed  by  the  merchant  to  his  English 
creditor,  reaches  London,  the  banker  there  will  have  author- 
ity to  pay  it.  For  the  Des  Moines  banker,  the  transaction  is 
cleared  up  by  a  cha'-ge  of  one  thousand  pounds  at  the  current 
sight  rate  made  by  the  New  York  bank  against  his  deposit; 
the  relations  of  the  New  York  bank  to  the  London  correspond- 
ent are,  of  course,  affected  by  this  transaction  precisely  as  if 
the  draft  had  been  drawn  by  the  New  York  banker,  himself. 
For  the  use  of  inland  bankers  who  are  their  regular  clients  in 
transactions  of  this  kind,  the  New  York  banks  publish  daily 
schedules  of  their  drawing  rates  on  the  principal  foreign  cen- 
ters. With  this  information  in  hand,  the  inland  banker,  by 
adding  the  commission  charge  he  is  obliged  to  pay  in  New 
York,  may  pass  on  the  total  charge  of  the  transaction  to  the 
buyer  of  the  demand  draft  in  the  form  of  a  rate  of  exchange. 

Certain  variations  of  the  process  just  described  are  to  be 
found.  The  drawing  inland  banker  may  not  keep  a  per- 
manent deposit  in  New  York,  but  may  remit  cover  for  each 
draft  drawn  (plus  the  New  York  banker's  commission)  at  the 
time  of  drawing,  employing  domestic  exchange  for  this  pur- 
pose. A  less  convenient  method  than  either  of  these,  and  one 
employed  only  by  inland  bankers  whose  dealings  in  foreign 
exchange  are  very  rare,  consists  in  receiving  the  client's 
money  together  with  a  memorandum  of  the  proposed  trans- 
action (the  amount  of  the  bill,  name  of  the  foreign  drawee, 
etc.)  and  sending  it  along  to  a  New  York  bank  with  a  request 
that  the  prescribed  draft  be  drawn  and  mailed.  The  delay 
involved  in  this  roundabout  procedure  prevents  its  use  by 
business  men  whose  need  for  foreign  exchange  is  at  all  regular. 

Various  methods  are  employed  by  the  foreign  exchange 
bankers  in  the  larger  cities  to  enable  them  to  draw  drafts  upon 
places  where  they  maintain  no  deposit.  There  are  certain 
cities,  of  course,  in  which  all  exchange  bankers  the  world  over 
carry  balances;  one  such  city  is  London,  another  Paris,  etc. 
These  central,  or  pivotal,  points  are  made  clearing  houses  for 
the  debits  and  credits  of  exchange  bankers  w^ho  wish  to  draw 
on  each  other  without  keeping  deposits  with  each  other.    If, 


BANKERS'  BILLS  OF  EXCHANGE  143 

for  example,  two  of  these  dealers,  situated  in  different  parts 
of  the  world,  have  balances  with  the  same  bank  in  London, 
one  may  draw  on  the  other  ,requesting  the  latter  to  recover  by 
drawing  on  the  London  bank.  Assume  that  the  First  Com- 
mercial Bank  of  New  York  and  the  Imperial  Ottoman  Bank 
of  Constantinople  are  both  correspondents  of  the  London  Ex- 
change Bank,  but  that  neither  carries  a  balance  with  the  other. 
A  request  comes  to  the  First  Commercial  Bank  to  draw  a  de- 
mand draft  payable  in  Turkish  pounds.  The  First  Commer- 
cial Bank  draws  this  draft  upon  the  Imperial  Ottoman  Bank, 
requests  the  latter  to  honor  it  and  reimburse  itself  by  drawing 
the  requisite  amount  of  sterling  upon  the  London  Exchange 
Bank.  The  First  Commercial  Bank  then  sends  advice  to  the 
London  Exchange  Bank,  instructing  it  to  pay  the  sterling 
demand  draft  drawn  in  Constantinople  out  of  the  Commer- 
cial Bank's  balance.  So  far  as  the  bankers  are  concerned, 
this  transaction  has  the  following  effects:  the  drawing  banker 
in  New  York  receives  money  from  the  buyer  of  the  demand 
draft  on  Constantinople  and  suffers  an  equivalent  loss  from 
his  London  balance;  the  drawee-banker  in  Constantinople 
expends  money  to  honor  this  draft,  but  acquires  a  like  sum  by 
selling,  at  once,  a  sterling  demand  draft;  the  London  banker 
merely  debits  the  account  kept  by  the  New  York  banker  with 
him.  The  cost  to  the  New  York  banker  of  supplying  this 
demand  draft  on  Constantinople  will  be  equal,  of  course,  to 
the  value  in  New  York  of  the  amount  subtracted  from  his 
London  balance  at  a  later  date.  How  much  this  subtraction 
will  be  depends  upon  the  sterling  sight  rate  in  Constantinople 
on  the  day  when  the  Imperial  Ottoman  Bank  honors  the  New 
York  banker's  demand  draft;  what  this  rate  will  be  cannot  be 
known  in  New  York  when  the  Turkish  draft  is  drawn.  Hence, 
the  New  York  banker  takes  a  risk  of  exchange  against  which 
he  provides  by  loading  the  price  he  asks  for  the  Turkish  de- 
mand draft. 

The  large  exchange  bankers  in  the  principal  world  centers 
hold  balances  for  a  great  number  of  bankers  in  different  parts 
of  the  world;  this  gives  them  the  opportunity  of  drawing 
against  these  correspondents  without  carrying  deposits  in  all 


144  FOREIGN  EXCHANGE 

the  foreign  cities  represented.  A  New  York  bank,  for  ex- 
ample, may  hold  a  balance  from  a  bank  in  Constantinople, 
but  carry  no  balance  with  this  correspondent.  It  may,  how- 
ever, draw  on  the  Constantinople  bank,  request  this  bank  to 
honor  the  draft,  and  offer  reimbursement  by  crediting  the 
drawee-banker's  balance  in  New  York.  Or,  the  Constanti- 
noi)le  bank  may  reimburse  itself  by  drawing  a  dollar  demand 
draft  on  New  York  for  the  necessary  amount,  which  draft 
the  New  York  banker  will  pay  without  subtraction  from  the 
balance  carried  by  the  bank  in  Constantinople.  By  methods 
such  as  these,  the  larger  banks  dealing  in  foreign  exchange 
are  enabled  to  draw  demand  drafts  on  most  of  the  markets  of 
the  world  without  maintaining  balances  in  all  of  these  markets. 
These  dealings  are,  of  course,  much  less  numerous  and  more 
irregular  than  those  which  involve  centers  more  closely  united, 
and  their  costs  to  the  buyers  of  the  drafts  are  higher. 

36.  Bankers'  long  bills.  Long  bills  drawn  by  bankers  are 
similar  to  demand  drafts  in  that  they  bear  the  names  of 
bankers  as  drawer  and  drawee  and,  so  far  as  appearance  goes, 
dissimilar  only  in  that  a  fixed  interval  of  time  must  elapse 
after  acceptance  before  the  drawee  can  be  called  upon  for  pay- 
ment. This  formal  distinction,  however,  leads  to  differences 
in  the  handling  of  bankers'  long  bills  which  are  of  great  sig- 
nificance. When  a  demand  draft,  drawn  by  an  American 
banker  upon  an  English  correspondent,  is  presented  for  pay- 
ment, a  charge  is  at  once  made  against  the  balance  of  the 
drawing  banker.  The  drawer  is,  accordingly,  compelled  to 
supply  cover  for  his  demand  drafts  either  in  advance  of,  or 
at  the  same  time  as,  his  sale  of  them.  A  long  bill,  on  the  other 
hand,  when  presented  to  the  drawee-bank,  is  not  paid,  but 
accepted,  and  is  charged  against  the  drawer's  acceptance 
account.  Although  it  becomes  the  legal  obligation  of  the 
acceptor,  not  greatly  differing  from  his  promissory  note,  the 
agreement  between  the  two  bankers  will  provide  that  the 
drawer  place  funds  in  the  hands  of  the  acceptor  in  sufficient 
time  to  meet  the  obligation  when  it  matures.  It  is  obvious 
that  this  cover  need  not  be  bought  until  some  days  after  the 
drawing  and  sale  of  the  bill,  an  interval  roughly  equal  to  the 


BANKERS'  BILLS  OF  EXCHANGE  145 

number  of  days  stated  on  the  bill's  face.  Thus,  the  drawer 
of  a  bankers'  long  bill  obtains  an  advance  of  funds  on  the 
strength  of  his  agreement  to  repay  at  a  later  date,  and  this 
feature  of  the  transaction  makes  of  this  type  of  bill  a  con- 
venient instrument  by  means  of  which  bankers  in  one  money 
center  borrow  the  current  funds  of  a  foreign  city  upon  the 
strength  of  the  acceptances  of  local  bankers. 

Furthermore,  the  translation  of  the  long  bill  into  the  ac- 
ceptance of  the  drawee-banker,  gives  the  holder  of  the  bill  a 
negotiable  instrument  which  may  readily  be  sold  in  the  dis- 
count market.  If  the  holder  retains  it  until  maturity,  he 
must  view  it  in  the  light  of  an  investment  for  the  life  of  the 
bill;  if  he  discounts  it  in  the  money  market,  the  next  buyer 
must  view  it  in  that  light.  Bankers'  long  bills  of  exchange  are, 
therefore,  much  affected  by  the  state  of  the  money  market, 
by  the  supply  of  funds  available  for  short-term  investment, 
and  the  rate  of  discount  which  obtains  at  the  time  of  drawing. 
These  aspects  of  the  bankers'  long  bill  will  be  elaborated  in 
the  following  pages;  before  proceeding,  however,  it  may  be 
well  to  illustrate  the  principal  features  of  this  type  of  foreign 
bill  of  exchange  by  means  of  a  typical  series  of  transactions. 

Assume,  then,  that  a  New  York  banker  draws  on  his  Lon- 
don correspondent  at  sixty  days'  sight  for  eight  thousand 
pounds  sterling  and  sells  the  bill  at  its  present  value  in  dollars 
and  cents  to  some  one  in  New  York.  The  buyer  of  this  bill 
will  have  supplied  himself  with  an  instrument  which  will  be 
worth  eight  thousand  pounds  sterling  sixty  days  after  its 
acceptance  in  London.  He  will  forward  it  to  some  one  in 
England  who  will  present  it  for  acceptance  and  sell  it  in  the 
discount  market,  or  hold  it  until  maturity.  Before  the  bill  is 
payable,  the  drawing  banker  will  have  supplied  the  London 
acceptor  with  funds  for  its  redemption.  The  supplying  of 
this  cover  may  be  done  in  such  a  way  as  either  to  close  out  the 
credit  relationship  created  between  the  two  bankers  by  the 
drawing  of  the  long  bill,  or  to  extend  this  relationship  over 
another  period.  If  the  former  of  these  alternatives  is  adopted, 
the  New  York  banker  will  buy  demand  drafts  worth  eight 
thousand  pounds  in  the  open  market  and  send  them  to  his 


146 


FOREIGN  EXCHANGE 


London  correspondent  for  encashment,  the  proceeds  being 
used  to  take  up  the  long  bill.  Or,  if  it  is  desired  to  postpone 
the  remittance  until  the  last  moment,  he  will  buy  a  cable 

Form  7.  Banker's  Sterlino  Long  Bill 


transfer  as  cover,  thus  gaining  an  extra  six  days  in  which  to 
use  the  funds  obtained  from  the  sale  of  his  sixty-day  draft. 

If  the  credit  is  to  be  renewed,  the  New  York  banker  will 
draw  a  second  long  bill  and  use  the  proceeds  of  its  sale  to  buy 
cover  for  the  first.  By  doing  this,  he  will  avoid  paying  out  of 
his  ouTi  funds  the  purchase  price  of  the  cover;  and  the  ob- 
ligation of  his  London  correspondent  will  not  be  terminated, 
but  extended  through  the  life  of  the  second  bill.  But  the 
second  bill  must  be  drawn  for  a  larger  amount  than  the  first. 


BANKERS'  BILLS  OF  EXCHANGE  147 

The  original  draft,  now  mature,  was  drawn  for  eight  thousand 
pounds  and  this  amount  must  be  placed  in  the  hands  of  the 
acceptor  for  its  redemption;  the  second  draft,  therefore,  must 
be  drawn  for  a  large  enough  amount  to  be  equivalent  to  eight 
thousand  pounds  in  demand  drafts  at  the  New  York  sight 
rate  on  London.  Now,  the  long  rate  is  always  lower  than  the 
sight  rate,  as  we  know;  hence,  the  second  long  bill  will  not  be 
worth  its  face  value  in  sight  drafts. 

To  illustrate  this  point,  let  us  assume  that  the  spread  be- 
tween the  sight  rate  and  the  rate  of  a  sixty-day  banker's  bill 
is  .0275  at  the  time  when  the  New  York  banker  undertakes 
to  cover  the  original  long  bill.  To  give  precision  to  our  illus- 
tration, we  will  suppose  that  the  two  rates  are  4.85  and 
4.8225  at  the  time  in  question.  ^  The  banker's  problem  is  to 
draw  a  long  bill  whose  sale  price  will  suffice  to  buy  eight  thou- 
sand pounds  in  sight  draft  at  the  sight  rate  of  4.85.  The  long 
bill  must,  therefore,  sell  for  $38,800  (8000  X  4.85).  Given  the 
rate  of  4.8225  for  the  long  bill,  its  face  must  be  8045.4  (38,800 
H- 4.8225).  The  second  long  bill  sold  at  this  rate  will  buy 
cover  for  the  first,  but,  obviously,  the  indebtedness  of  the 
drawing  banker  will  be  increased  in  the  process  of  extending 
the  loan. 

It  is  sometimes  the  practice  for  the  drawing  banker,  who  is 
obliged  to  cover  a  maturing  long  bill,  to  "swap"  the  second 
bill  for  the  amount  of  cover  required.  This  exchange  is 
made  with  another  banker  in  his  market  who  can  use  the  long 
bill  to  make  delivery  on  a  futures  contract,  or  in  some  other 
manner,  and  is  willing  to  exchange  demand  drafts  for  it. 
The  practice,  in  this  case,  is  to  swap  equal  amounts  —  in  our 
illustration,  a  long  bill  of  eight  thousand  pounds  for  demand 
drafts  of  the  same  amount  —  and,  to  square  accounts,  the 
holder  of  the  long  bill  pays  the  holder  of  the  demand  drafts 
the  difference  between  the  long  and  sight  rates  of  exchange 
multiplied  by  the  face  of  the  bills.  Given  the  rates  of  ex- 
change used  in  the  preceding  illustration,  the  swap  would  be 
effected  by  the  exchange  of  a  sixty-day  sterling  sight  bill  of 
eight  thousand  pounds  for  a  sterling  demand  draft  of  the 
^  See  calculation  on  p.  89. 


148  FOREIGN  EXCHANGE 

same  amount,  the  drawer  of  the  long  bill  paying  the  drawer 
of  the  domand  draft  a  premium  of  $220  (8000  X  .0275). 
This  constitutes  an  exchange  of  equal  values  in  New  York  and 
results  in  giving  each  of  the  bankers  the  type  of  sterling  bill 
which  he  needs.  Swaps  of  this  kind  are  very  frequent  occur- 
rences in  the  New  York  market. 

To  sum  up  the  relationships  created  by  the  drawing  of  a 
long  bill  by  one  banker  of  another:  The  drawing  banker  ob- 
tains an  advance  of  funds  on  the  strength  of  his  correspond- 
ent's credit.  The  advance  is  not  made  by  the  correspondent, 
for  he  pays  out  no  money  of  his  own  at  any  stage  in  the  opera- 
tion. The  buyer  of  the  banker's  long  bill  in  New  York  may 
bear  the  burden  of  this  advance,  though  he  does  not  bear  it 
of  necessity;  for  in  buying  the  bill  he  will  pay  its  present 
(discounted)  value,  and  this  sum  he  is  at  liberty  to  recover  by 
selling  it  in  the  open  money  market  of  London  at  the  time  of 
acceptance.  Only  if  the  buyer  chooses  to  retain  the  accept- 
ance until  maturity  will  he  make  an  advance  of  funds ;  other- 
wise —  and  this  is  the  almost  universal  practice  —  the  burden 
will  be  passed  on  to  that  investor  in  the  foreign  money  mar- 
ket who  buys  the  acceptance. 

37.  Finance  bills.  The  ieYva.  finance  bill  is  applied  to  those 
drafts  w^hose  object  is  solely  to  effect  a  loan  of  funds  between 
the  money  centeis  involved.  A  little  reflection  will  disclose 
the  fact  that  the  banker's  long  bill  results  in  an  advance  of 
funds  to  the  drawing  banker  only  when  the  purchase  of  cover 
is  postponed,  for  if  the  cover  has  been  bought  previously  to 
the  sale  of  the  bill,  or  is  bought  at  the  same  time,  the  trans- 
action will  not  increase  the  funds  in  the  hands  of  the  drawer. 
A  great  proportion  —  perhaps  the  majority  —  of  bankers* 
long  bills  do  not  represent  lending  operations.  There,  are 
many  transactions  in  which  they  can  be  used  to  recover 
money  already  expended  in  foreign  exchange.  A  common 
transaction  of  this  nature  is  the  sale  of  a  banker's  long  bill  to 
offset  previous  purchases  of  commercial  bills,  usually  docu- 
mentary payment  bills,  whose  redemption  at  maturity,  or 
by  prepayment  on  the  part  of  the  drawee,  will  increase  the 
banker's  foreign  balance  at  some  future  date.    The  purchase 


BANKERS'  BILLS  OF  EXCHANGE  149 

of  payment  bills  always  leaves  the  banker  in  doubt  as  to  when, 
and  by  what  amount,  they  will  add  to  his  foreign  credit,  and, 
consequently,  in  doubt  as  to  the  rate  of  exchange  at  which  he 
can  sell  his  demand  drafts  against  their  proceeds.  To  wait 
until  the  completion  of  each  deal  in  such  bills  will  expose  the 
banker  to  the  risk  of  adverse  changes  in  the  rates;  to  avoid 
this  risk  he  may  attempt  to  classify  his  holdings  of  documen- 
tary payment  bills  upon  the  basis  of  past  experience,  deter- 
mining within  limits  how  much  they  will  increase  his  foreign 
credits  upon  certain  definite  futm-e  dates.  He  will  then  be 
prepared  to  sell  his  own  long  bills,  so  arranged  in  usance  and 
amount  as  to  exhaust  these  expected  balances  as  rapidly  as 
they  accrue,  taking  his  chance  of  overdrawing  on  certain  days 
and  failing  to  exhaust  his  credit  upon  others.  Obviously,  no 
borrowing  is  involved  in  such  use  of  long  bills,  since  cover  is 
provided  at  least  as  soon  as  the  bill  is  sold.  It  is  when  funds 
are  raised  by  the  sale  of  the  long  bill  in  advance  of  the  expend- 
iture necessary  to  provide  cover  that  the  bill  serves  the 
purpose  of  international  lending,  and  is  called  a  finance  bill. 
Finance  bills  are  drawn  when  there  is  sufiicient  difference 
in  the  rates  of  interest  obtaining  in  two  markets  to  make  it 
profitable  to  borrow  in  one  and  lend  in  the  other.  In  explana- 
tion of  this  statement,  we  must  repeat  that  the  sale  price  in 
New  York  of  a  long  bill  drawn  on  London  will  be  determined 
by  the  discount  rate  in  the  London  money  market,  for  it  is  in 
that  market  that  the  accepted  bill  will  be  offered  for  sale. 
The  funds  raised  by  the  sale  of  this  bill  will  lie  in  the  hands 
of  the  New  York  banker  to  be  loaned  in  his  own  market. 
Assuming,  now,  that  the  discount  rate  in  the  London  market 
is  4  per  cent,  while  the  interest  rate  in  New  York  is  6  per  cent, 
it  follows  that  the  drawing  banker  can  discount  his  bill  at  the 
lower  rate  and  lend  the  proceeds  at  the  higher  during  the 
time  which  elapses  before  he  is  compelled  to  buy  cover.  It  is 
this  divergence  of  the  rates  of  interest  which  encourages  the 
two  correspondent  bankers  to  put  through  a  transaction  in 
finance  bills.  The  profit  from  the  transaction  may  be  divided 
in  various  ways.  The  drawing  banker  may  take  the  initia- 
tive throughout,  carrying  through  the  operation  at  his  own 


150  FOREIGN  EXCHANGE 

risk  ami  profit,  and  paying  a  commission  to  the  accepting 
banker  for  the  use  of  his  name.  Or,  the  accepting  banker 
may  take  the  initiative,  fnstructing  his  correspondent  to  draw 
against  him,  specifying  the  use  which  may  be  made  of  the 
funds  and  paying  him  a  commission  for  attending  to  the  de- 
taiks  of  the  transaction.  Or,  again,  the  operation  may  be 
carried  through  on  joint  account,  with  a  division  of  profit  or 
loss  between  the  two  correspondents.  But  these  differences 
of  detail  do  not  change  the  nature  of  the  finance  bill,  or  the 
method  of  handling  it,  in  any  essential  respect. 

The  exact  nature  of  this  process  of  borrowing  in  one  market 
and  lending  in  another  requires  some  explanation.  It  does 
not  involve  the  transfer  of  funds  between  the  two  markets, 
but  only  a  redirection  of  the  credit  resources  of  each.  Sup- 
pose, for  example,  that  because  there  is  a  relatively  large  sup- 
ply of  loan  funds  in  London  and  a  relative  scarcity  in  New 
York,  the  discount  rate  in  London  is  4  per  cent  at  a  time 
when  money  can  be  loaned  on  good  security  at  6  per  cent 
in  New  York.  If  a  finance  bill  for  ten  thousand  pounds  is 
drawn  at  ninety  days'  sight  by  a  New  York  banker,  the  pro- 
ceeds may  be  loaned  on  the  day  of  drawing,  while  about  six 
days  must  pass  before  the  bill  arrives  in  London  and  is  pre- 
sented for  acceptance;  hence  the  loan,  made  by  the  draw- 
ing banker  in  New  York,  will  mature  six  days  earlier  than 
the  acceptance,  and  the  New  York  banker  will  have  time  to 
supply  his  London  correspondent  with  cover. 

Now,  care  must  be  taken  to  untangle  the  credit  relation- 
ships created  by  this  transaction.  The  New  York  banker 
has  obtained  funds  by  selling  at  its  present  value  a  ten-thou- 
sand-pound ninety-day  draft  on  London,  and  he  has  the  use 
of  these  funds  for  ninety  days;  this  money  he  received,  in  the 
first  instance,  from  that  individual  in  New  York  who  bought 
the  finance  bill.  But  this  buyer  will  not  have  made  an  ad- 
vance of  funds;  he  has  been  under  the  necessity  for  making  a 
remittance  to  England,  and  has  bought  the  finance  bill  be- 
cause it  would  serve  as  an  instrument  for  making  this  remit- 
tance. If  the  finance  bill  had  not  been  drawn,  he  would  have 
been  compelled  to  employ  some  other  method  for  making  his 


BANKERS'  BILLS  OF  EXCHANGE  151 

remittance  —  demand  drafts,  or  bankers'  long  bills  covered 
in  advance  of  drawing  —  a  method  which  would  have  left  no 
loanable  funds  in  the  hands  of  the  drawing  banker.  He  buys 
the  finance  bill  and  sends  it  to  his  English  creditor  who  ob- 
tains the  money  due  him  from  that  investor  in  the  money  mar- 
ket of  London  who  buys  the  bill  after  acceptance.  Hence, 
the  credit  resources  of  London  are  absorbed  in  cancelling  pay- 
ments due  from  American  debtors;  while  the  money  of  these 
debtors  remains  in  New  York  available  for  loans  to  the  busi- 
ness men  of  that  city.  This  is  virtually  equivalent  to  the 
transfer  of  loan  funds  from  London  to  New  York,  since  the 
effect  of  the  operation  is  the  enlisting  of  a  part  of  London's 
credit  in  doing  the  business  of  New  York;  the  effect  is  pro- 
duced, however,  not  by  an  actual  transfer  of  funds,  but  by  a 
redirection  of  those  funds  within  each  market. 

38.  The  dollar  loan.  Wherein  Hes  the  profit  to  the 
bankers  who  engage  in  operations  in  finance  bills?  To  an- 
swer this  question  we  must  first  distinguish  between  two  vari- 
eties of  finance  bills:  the  dollar  loan  and  the  sterling  loan. 
In  the  case  considered  above,  the  loan  was  made  by  the  draw- 
ing banker  in  dollars  and  was  repaid  by  the  borrower  in  dol- 
lars, with  interest.  If  any  profit  is  to  be  left  in  the  hands  of 
the  bankers  when  the  transaction  is  completed,  it  will  be  due 
to  the  fact  that  the  number  of  dollars  repaid  by  the  borrower 
will  be  more  than  sufficient  to  buy  the  demand  drafts  which 
cover  the  finance  bill  at  maturity.  Now  the  bankers  cannot 
foretell  what  the  sight  rate  for  sterling  in  New  York  will  be 
at  the  time  the  demand  drafts  are  bought;  they,  therefore, 
do  not  know  by  what  amount,  if  any,  the  money  returned  by 
the  borrower  will  exceed  the  value  of  the  ten  thousand  pounds 
in  demand  drafts  which  must  be  bought  to  close  out  the  trans- 
action. In  other  words,  their  profit  is  bound  up  with  the 
future  course  of  the  exchange  rates,  and  in  making  a  dollar 
loan,  through  the  agency  of  a  finance  bill,  they  are  choosing 
to  speculate  in  the  exchange  market  of  New  York.  To  make 
this  point  clear,  let  us  compute  the  effect  upon  the  profit  of 
the  bankers  which  will  follow  certain  changes  in  the  sterling 
rates. 


152  FOREIGN  EXCHANGE 

The  conditions  of  the  problem  are  these: 

(1)  Sale  of  ninety-day  sterling  bill  for  ten  thousand  pounds 
at  the  existing  rate  of  exchange;  London  discount  rate, 
4  per  cent. 

(2)  Loan  of  the  proceeds  in  dollars  at  6  per  cent  for  ninety 
days  in  New  York. 

(3)  Purchase  of  demand  sterling  with  the  returns  from  the 
loan. 

Let  the  sight  rate  on  the  day  of  sale  be  4.85;  the  rate  for  a 
ninety-day  bankers'  bill  derived  from  this  quotation  when 
the  London  discount  rate  is  4  per  cent  will  be  4.809. 

£10,000@4.809 $48,090.00 

Interest  ($48,090  X  .06  X  90/365) 725.10 

Amount  repaid,  loan  plus  interest $48,815.10 

The  New  York  banker  will  have  $48,815.10  with  which  to 
buy  sterling  demand  drafts  to  cover  the  finance  bill.  Assum- 
ing that  the  sight  rate  has  not  changed,  this  amount  will  buy: 

$48,815.10  -^  4.85 £10,064.97 

Face  of  finance  bill 10,000.00 

Profit £64.97 

Assume,  again,  that  the  sight  rate  has  risen  to  4.88,  the  eJBfect 
on  the  bankers'  profit  will  be  as  follows : 

$48,815.10V  4.88 £10,003.09 

Face  of  finance  bill 10,000.00 

Profit £3.09 

Again,  let  the  sight  rate  fall  to  4.83,  and  the  profit  will  be 
affected  as  follows: 

$48,815.10  -^  4.83 £10,104.57 

Face  of  finance  bill 10,000.00 

Profit £104.57 

These  calculations  show  that,  when  the  proceeds  of  a  fi- 
nance bill  are  used  to  make  a  loan  in  dollars,  the  profit  from 
the  transaction  will  vary  inversely  with  variations  in  the 
rate  for  sterling  sight  drafts  between  the  time  of  lending  and 
the  purchase  of  cover. 


BANKERS'  BILLS  OF  EXCHANGE  153 

The  risk  run  by  the  bankers  when  they  draw  finance  bills 
for  the  purpose  of  making  dollar  loans  is  not  unavoidable;  it 
is  possible  for  them  to  hedge  the  transaction  at  the  time  the 
bill  is  sold  by  buying  a  contract  which  calls  for  the  delivery 
of  the  required  amount  of  sight  drafts  on  the  day  when  cover 
is  needed.  The  hedge  will  make  it  possible  for  the  bankers  to 
foretell  what  the  cover  for  the  finance  bill  will  cost,  and  so  to 
determine  whether  it  is  profitable  for  them  to  make  the  loan 
at  all.  If,  rather  than  secure  themselves  against  the  risk  of 
changes  in  the  rates,  they  choose  to  take  the  chance  of  loss, 
it  must  be  because  they  expect  the  rates  to  take  a  downward 
course;  that  is  to  say,  they  become  speculators  selling  short 
of  exchange  in  the  hope  of  a  break  in  the  market.  The  appear- 
ance of  dollar  loans  in  large  amounts,  when  these  loans  are 
financed  by  the  drawing  of  bankers'  long  bills  in  sterling, 
mark,  franc,  or  other  exchange,  is  therefore  an  indication 
that  the  operators  in  the  exchange  market  are  predicting  a 
decline  in  the  quotations  on  the  demand  bills  drawn  in  these 
moneys. 

39.  The  sterling  loan.  In  the  preceding  illustration,  the 
finance  bill  was  first  sold,  then  the  proceeds  were  loaned  in 
the  New  York  market.  If,  instead  of  proceeding  in  this 
manner,  the  drawing  banker  had  loaned  the  original  sterling 
long  bill,  the  borrower  agreeing  to  return  an  equal  amount  of 
sterling  sight  drafts  at  the  term  of  the  loan,  the  parties  to  the 
finance  bill  would  have  been  relieved  of  all  concern  as  to  the 
future  changes  in  the  sterling  rates.  For,  obviously,  no 
possible  fluctuation  of  the  rates  can  alter  the  fact  that  the 
borrower  must  return  exactly  the  amount  of  sight  drafts  re- 
quired to  cover  the  maturing  finance  bill.  On  the  other  hand, 
and  for  the  same  reason,  neither  of  the  bankers  whose  names 
appear  upon  the  finance  bill  can  make  a  profit  from  the  trans- 
action; unless  the  borrower  fails  to  re])ay  the  loan,  the  re- 
ceipts of  the  bankers  on  the  day  their  finance  bill  becomes 
payable  will  just  suffice  to  meet  their  obligation.  When  the 
sterling  loan  is  made,  therefore,  the  banks  act  as  agents,  re- 
ceiving a  commission  for  the  use  of  their  names,  while  the  risk 
and  the  profit  are  taken  by  the  borrower  of  the  bill.     We  may 


154  FOREIGN  EXCIL\NGE 

illustralc  this  distinclion  between  the  dollar  and  the  sterling 
loan  hy  means  of  the  same  data  used  in  the  preceding  section. 

Assume,  then,  that  the  interest  rates  of  London  and  New 
York  are  4  per  cent  and  6  per  cent,  respectively,  and  that  the 
amount  of  the  finance  bill  is  ten  thousand  pounds.  Some 
individual  in  New  York,  having  arranged  with  the  drawing 
banker  to  borrow  the  bill,  will  deposit  collateral  and  contract 
to  return  ten  thousand  pounds  in  demand  drafts  ninety  days 
later.  No  interest  will  be  charged  the  borrow^er  for  this  loan; 
why  this  is  so,  we  shall  see  in  a  moment.  The  borrower  will 
sell  the  finance  bill  in  the  open  market;  it  wnll  be  forwarded 
to  London  for  acceptance,  discounted  in  the  London  market, 
and  presented  for  payment  ninety  days  later.  But  before  it 
matures,  the  borrower  in  New  York  will  have  repaid  the  loan 
by  giving  the  drawer  ten  thousand  pounds  in  demand  drafts, 
and  these  drafts  will  be  placed  in  the  hands  of  the  London  ac- 
ceptor in  time  to  redeem  the  finance  bill.  As  their  profit 
from  this  transaction,  the  two  bankers  will  receive  from  the 
borrower  of  the  finance  bill  a  commission  of  something  like 
S/8  per  cent  per  annum  on  the  ten  thousand  pounds. 

The  reason  why  the  borrower  of  the  finance  bill  was 
charged  no  specific  rate  of  interest  upon  his  indebtedness  is 
this:  an  interest  rate  is  concealed  in  the  difference  between 
the  rate  of  exchange  for  the  banker's  long  bill  which  he  bor- 
rows and  the  higher  rate  of  exchange  for  the  sight  drafts 
which  he  obligates  himself  to  return.  To  make  the  loan 
effective  for  the  purposes  of  his  business,  he  must  sell  the  long 
bill  for  dollars,  and  the  rate  at  w^hich  he  can  sell  it  will  involve 
a  discount  from  .its  face  at  the  rate  of  interest  obtaining  in 
the  money  market  of  London.  When  buying  sight  drafts 
with  which  to  redeem  his  loan,  the  borrower  w411  have  to  pay 
a  price  undiminished  by  discount;  and  unless  a  very  marked 
change  has  taken  place  in  the  rates  since  the  time  the  finance 
bill  was  borrowed,  he  wdll  be  required  to  expend  more  dollars 
than  he  received  from  the  sale  of  the  finance  bill.  Looking 
at  the  matter  from  the  point  of  view  of  the  drawing  banker, 
this  concealed  interest  charge  can  be  clearly  seen.  \Mien  the 
ten  thousand  pounds  in  sight  drafts  are  returned,  the  value  of 


BANKERS'  BILLS  OF  EXCHANGE  155 

these  drafts  in  dollars  will  be  greater  than  the  value  of  a 
banker's  long  Ijill  drawn  for  the  same  amount  —  as  much 
greater,  in  fact,  as  the  amount  of  the  discount  which  the  long 
bill  will  suffer  when  sold  in  the  London  market.  The  original 
finance  bill  has  been  growing  in  value  as  it  lay  in  the  hands  of 
the  investor  in  the  market  of  London;  this  investor  has  been 
gaining  interest  as  the  bill  which  he  bought  at  its  reduced  value 
has  been  approaching  maturity.  This  interest  gained  by  the 
investor  in  London  is  borne  by  the  borrower  in  New  York, 
who  sold  the  finance  bill  at  its  discounted  value  and  bought 
cover  for  it  when  it  had  matured.  In  addition  to  this  loss  of 
interest,  the  borrower  must  bear  the  commission  charge  of  the 
bankers. 

Usually  the  borrowers  of  finance  bills  are  themselves 
bankers  who  intend  to  loan  out  the  money  raised  from  the 
sale  of  the  bill  at  the  higher  rate  of  interest  which  obtains  in 
the  New  York  market.  When  their  transaction  is  wound  up 
and  they  buy  the  demand  drafts  with  which  to  repay  their 
loan,  if  any  profit  is  to  remain  in  their  hands  the  interest 
earned  by  the  money  which  they  have  been  lending  must 
exceed  in  amount  the  excess  cost  of  the  demand  drafts  plus 
the  commission  which  they  must  pay.  This  may  be  illus- 
trated by  a  simple  calculation.  Taking  the  same  figures  as  in 
the  preceding  illustration,  let  us  assume  that  a  ten-thousand- 
pound  ninety-day,  sterling  bill  is  borrowed  when  the  discount 
rate  in  London  is  4  per  cent;  that  this  bill  is  sold  in  the  New 
York  market  and  the  proceeds  loaned  at  6  per  cent  for  ninety 
days;  the  borrower  of  the  sterling  bill  to  return  ten  thousand 
pounds  in  sterling  sight  drafts  and  to  pay  3/8  per  cent  com- 
mission charge.  Under  the  conditions  assumed,  if  the  sterling 
sight  rate  in  New  York  on  the  day  the  finance  bill  is  drawn  is 
4.85,  the  finance  bill  will  sell  at  4.809. 

£10,000® 4.809 $48,090.00 

Interest  ($48,090  X  .06  X  90/305) 72r).l0 

$48,815.10 

When  the  loan  has  reached  maturity,  the  borrower  of  the  fi- 
nance bill  will  have  $48,815.10  with  which  *;o  buy  the  tea 


150  FOREIGN  EXCHANGE 

Ihousand  pounds  in  sight  drafts  which  he  must  return  to  the 
tlrawer  t)f  I  ho  finance  hill.  If  I  he  sight  rale  has  remained  un- 
changed, the  cost  of  this  cover  will  be: 

£10,000  X  4.85 $48,500.00 

Commission  (3/8  per  cent  X  48,500  X  90/305)  .  44.85 

Cost  of  cover $48,544.85 

Hence,  his  profit  will  be  $48,815.10- 48,544.85  =  $270.25. 
Clearly,  the  amount  of  this  profit  depends  upon  the  behavior 
of  the  sterling  sight  rate  between  the  time  the  finance  bill  is 
borrowed  and  the  time  cover  is  bought;  any  increase  in  the 
sight  rate  will  cut  down  the  profit,  and  any  decline  will  aug- 
ment it.  Consequently,  the  borrower  of  a  sterling  loan  (like 
the  accepting  banker  in  case  of  the  dollar  loan),  unless  he 
hedges  his  transaction  by  buying  a  contract  for  the  future 
delivery  of  the  required  amount  of  sight  drafts,  is  speculating 
—  selling  short  of  exchange  in  the  hope  of  a  break  in  the  mar- 
ket. Consequently,  the  appearance  in  the  market  of  finance 
bills  in  large  quantity,  whether  they  are  of  the  dollar  or  the 
sterling  loan  varieties,  may  be  taken  as  an  indication  that  the 
exchange  dealers  are  con\nnced  that  the  sterling  sight  rate  is 
about  to  fall.  All  that  has  been  said  above  regarding  the 
sterling  finance  bill  applies  without  qualification  to  finance 
bills  drawTi  in  francs,  marks,  lire,  and  other  foreign  moneys. 
In  normal  times,  preceding  the  Great  War,  the  currents  of 
our  foreign  commerce  were  such  as  to  cause  seasonal  swnngs 
downward  and  upward  in  the  rates  of  exchange  harmonizing 
with  the  rising  and  falling  volume  of  commercial  bills  brought 
into  the  market.  Finance  bills  have  played  their  part  in 
mitigating  these  fluctuations;  for,  whenever  the  relation  of  the 
discount  rates  in  New  York  and  foreign  markets  was  favor- 
able, certain  banking  houses  made  a  practice  of  selling  finance 
bills  if  a  downward  swdng  of  the  exchange  rates  was  expected. 
This  would  be  at  a  time  when  commercial  bills  w^ere  in  light 
supply  and  bankers'  demand  drafts  in  large  demand;  for  then 
the  exchange  rates  would  be  high.  But  by  selling  finance  bills 
at  a  time  when  bills  were  scarce,  the  bankers  have  added  to 
the  supply  of  available  means  whereby  American  business 


BANKERS'  BILLS  OF  EXCHANGE  157 

men  could  make  their  remittances  to  foreign  markets,  and, 
consequently,  their  action  has  served  to  restrain  the  rates 
from  rising  to  the  extreme  quotations  to  which  the  compe- 
tition of  the  buyers  might  have  pushed  them.  As  has  been 
said,  the  sellers  of  these  finance  bills  have  expected  a  decline 
in  the  rates;  but  they  have  been  compelled  to  buy  cover  in  the 
declining  market  and  have,  thus,  restrained  the  rates  from 
falling  as  low  as  they  might  otherwise  have  gone. 

Until  very  recent  years,  similar  selling  in  foreign  markets 
of  finance  bills  drawn  on  New  York  has  been  a  rare  occur- 
rence. Many  factors  have  cooperated  to  produce  this  result. 
Most  American  bankers  have  been  prevented  by  the  state  of 
our  law  from  accepting  the  drafts  of  foreign  correspondents; 
moreover,  there  has  not  been  in  New  York  a  smoothly 
functioning  discount  market  in  which  acceptances  could  be 
sold;  also,  the  rates  of  interest  in  New  York  have  customarily 
been  higher,  not  lower,  than  those  of  foreign  centers.  These 
handicaps  have  been  removed  to  a  large  extent  by  changes 
which  will  be  described  in  another  place,  ^  so  that,  to-day, 
finance  bills  on  New  York  are  drawn  by  foreign  bankers  in 
large  amounts. 

The  speculative  nature  of  the  finance  bill  has  caused  it  to 
be  condemned  by  authorities  on  foreign  exchange  and  by 
bankers  in  the  world's  money  centers.  The  ready  discount 
market  of  London,  and  the  central  position  held  by  sterhng 
exchange  in  all  financial  centers,  has  brought  it  about  that  by 
far  the  major  proportion  of  finance  bills  were  drawn  in  sterling. 
These  bills  periodically  filled  the  portfoUos  of  the  money- 
lenders of  London  and  absorbed  the  loanable  funds  of  that  city 
which  might  have  been  devoted  to  different  purposes.  The 
Governors  of  the  Bank  of  England,  and  the  more  conservative 
private  bankers  of  that  market,  have  considered  this  recurring 
tendency  to  flood  the  discount  market  with  bills  drawn  to 
finance  foreign  lending  operations  as  one  unworthy  of  en- 
couragement. The  practice  of  bankers  who  lend  their  names 
as  acceptors  of  these  bills  has  been  viewed  as  a  business  enter- 
prise of  doubtful  virtue,  very  similar  to  the  practice  of  ac- 
» See  Chapter  XIV. 


15S  FOREIGN  EXCHANGE 

commodation  endorsement.  This  condemnation  of  the  fi- 
nance bill  is  to  a  large  degree  sound.  The  houses  which  ac- 
cei)t  these  hills  in  great  amounts  do  certainly  run  considerable 
risk  that  their  correspondents,  the  drawers,  may  be  unable  to 
supply  cover  in  time  to  take  up  the  acceptances,  in  which  con- 
tingency, the  l)urden  of  redeeming  them  must  fall  upon  the 
London  bankers.  It  does  not  make  for  stability  in  the 
money  market  to  have  the  assets  of  the  banks  committed  to 
the  support  of  speculative  operations  in  foreign  markets,  for 
such  a  condition  of  affairs  will  make  more  direct  and  powerful 
the  shock  suffered  by  the  credit  structure  of  London  from 
any  business  depression  or  panic  in  the  money  centers  of  other 
countries.  Because  of  this  attitude  toward  jBnance  bills, 
they  have  frequently  been  discriminated  against  by  the  Bank 
of  England  when  rediscounting  the  acceptances  of  brokers. 
To  minimize  the  danger  of  loss,  the  accepting  houses  in  Lon- 
don have  made  it  their  custom  to  demand  the  best  collateral 
in  the  case  of  dollar  or  sterling  loans  in  New  York  or  else- 
where. 


CHAPTER  Vn 

COMMERCIAL  BILLS 

40.  Definition  and  classification.  At  the  basis  of  the  for- 
eign exchange  business  of  the  world  lies  the  vast  complex  of 
international  trade  in  commodities,  services,  and  securities 
as  a  result  of  which  the  business  men  of  different  countries 
develop  among  themselves  creditor-debtor  relationships. 
Bills  of  exchange  which  arise  from  commercial  transactions 
as  an  aid  to  the  business  man  in  his  effort  to  collect  payment 
from  foreign  debtors  are,  therefore,  the  primary  material  of 
the  exchange  market.  Bankers'  bills  are  of  subordinate  im- 
portance, being  either  the  product  of  prior  transactions  in- 
volving the  bills  of  merchants,  or  else  of  a  temporary  con- 
dition of  the  exchange  market.  Bills  of  exchange  are  called 
commercial  bills  when  drawn  by  a  business  man,  usually  as  a 
part  of  a  commercial  transaction  which  consisted  of  a  sale 
made  by  him  to  a  foreign  customer. 

It  is  inevitable  that  commercial  bills  vary  greatly  in  form. 
So  vast  is  international  trade,  so  various  the  goods  and  the 
markets  with  which  it  is  concerned,  and  so  different  the 
character  and  the  credit  standing  of  the  business  men  who 
engage  in  it,  that  the  bills  of  exchange  which  represent  these 
countless  transactions  cannot  be  uniform.  Bills  of  exchange 
which  answer  the  purpose  of  an  exporter  of  perishable  fruits 
are  usually  of  shorter  term  than  those  drawn  against  ship- 
ments of  machinery;  bills  created  by  merchants  of  low  credit 
rating  are  almost  invariably  supported  by  collateral  security, 
while  those  of  firms  of  the  highest  standing  are  sometimes 
negotiated  by  bankers  on  the  strength  of  the  drawer's  signa- 
ture alone;  bills  which  pass  through  the  banks  of  two  nations 
of  similar  culture  and  business  practice  do  not  receive  the 
same  treatment  as  those  which  involve  markets  where  mutual 
understanding  is  diflScult.    Consequently  our  description  of 


1(50  FOREIGN  EXCHANGE 

commercial  bills  cannot  lay  claim  to  completeness  nor  is  it 
possible  to  treat  of  each  method  of  handling  the  various  kinds 
of  hills  in  the  exchange  markets;  we  must  limit  our  attention 
to  those  forms  hy  means  of  which  the  preponderance  of  the 
world's  trade  is  financed.  The  following  classification  era- 
braces  all  the  types  of  commercial  bills  whose  appearance  in 
the  exchange  market  is  a  customary  phase  of  international 
trade: 
I.  Commercial  long  bills. 

A.  Bills  with  documents  attached,  called  documen- 
tary bills. 

1.  Acceptance  bills:  documents  delivered  against 
acceptance, 

2.  Payment  bills:  documents  delivered  against 
payment. 

B.  Bills  free  from  documents:  called  clean  bills, 
II.  Commercial  bills  at  short  sight  or  date.     ' 

III.  Commercial  letters  of  credit. 

41.  Commercial  long  bills.  Payment  for  goods  either  in 
advance  or  cash  on  delivery  is  the  exception  in  international 
trade;  customarily  the  terms  of  sale  are  adjusted  to  allow  the 
buyer  a  period  of  time  in  which  to  prepare  for  payment  after 
the  goods  have  been  shipped.  The  length  of  this  period  is 
determined  by  bargain  between  buyer  and  seller  just  as  are  all 
other  details  of  the  commercial  transaction,  and  in  each  case 
the  bill  of  exchange  must  be  drawn  to  mature  at  the  end  of 
the  credit  period.  It  is  the  custom  of  the  exchange  market 
to  apply  the  term  "long  bill"  to  any  draft  whose  term  of  life 
extends  beyond  thirty  days.  The  draft  running  sixty  or 
ninety  days  after  acceptance  is  the  typical  credit  instrument 
in  the  commercial  relations  of  most  of  the  world's  chief  mar- 
kets. 

However,  the  exporter  who  has  sold  his  goods  "on  time" 
to  a  foreign  customer  is  not  usually  content  to  wait  until  the 
end  of  the  credit  period  before  receiving  payment  for  his 
goods.  Ordinarily,  he  will  attempt  to  realize  upon  the  trans- 
action by  obtaining  from  a  banker  an  advance  of  funds  to  the 
amount  of  his  bill  of  exchange,  bearing  the  cost  of  the 


COMMERCIAL  BILLS  161 

banker's  services  and  the  loss  of  interest  ^  which  results  from 
the  discount  of  his  bill,  in  order  to  escape  the  burden  of  wait- 
ing. Nor  is  the  banker  who  acquires  the  exporter's  bill  usu- 
ally content  to  wait  until  it  matures  before  regaining  posses- 
sion of  his  funds.  When  the  bill  has  received  the  acceptance 
of  the  drawer,  it  will  have  become  an  investment  instrument 
of  high  standing,  since  it  rests  upon  the  credit  of  both  drawer 
and  acceptor.  The  banker  may,  accordingly,  pass  it  on  io 
some  broker  or  money-lender  in  the  discount  market  who  is 
willing  to  invest  in  it  for  the  gain  of  interest.  For  the  sake  of 
clarity,  we  shall  for  the  present  assume  a  uniformity  which 
does  not  exist,  and  reduce  the  life-history  of  the  typical  com- 
mercial long  bill  to  the  following  phases : 

(1)  It  is  drawn  by  a  merchant  against  a  foreign  customer 
or  the  customer's  bank. 

(2)  It  is  acquired  by  the  drawer's  banker  by  an  advance  of 
funds  and  forwarded  to  a  foreign  correspondent  for 
presentment. 

(3)  It  is  accepted  by  the  drawee. 

(4)  It  is  sold  in  the  discount  market  by  the  correspondent 
bank  and  the  buying  banker's  foreign  balance  is  in- 
creased by  the  amount  of  the  proceeds. 

(5)  It  is  redeemed  at  maturity  by  the  acceptor. 

In  the  present  chapter,  we  are  concerned  primarily  with  a 
description  of  the  bills  themselves,  and  not  with  the  methods 
adopted  by  the  exchange  markets  in  handling  them.  It  may 
be  well,  however,  to  pause  long  enough  to  remark  that  not  all 
commercial  bills  pass  through  the  stages  outlined  above;  the 
chief  differences  appear  with  regard  to  the  second  and  fourth 
stages.  The  exporter's  bill  may  be  of  such  a  nature  that  the 
banker  is  unwilling  to  buy  it  outright,  in  which  case  the  ex- 
porter must  deposit  it  for  collection  and  wait  for  the  proceeds 
until  the  bill  has  been  redeemed.  Or,  the  banker,  though 
unwilling  to  purchase  the  bill,  may  make  use  of  it  as  collateral 
for  a  loan  to  the  exporter  of  a  part  of  its  face.     It  is  needless 

^  The  exporter,  normally,  passes  this  interest  loss  on  to  the  importer 
through  hif,'her  prices.  He  could,  however,  retain  the  proceeds  of  the  higher 
prices  for  himself  if  he  cared  to  wait  for  his  returns. 


1G2  FOREIGN  EXCHANGE 

to  say  that  when  the  second  stage  in  the  life-history  of  the 
bill  is  niodifiod  in  this  manner,  the  fourth  stage  is  omitted 
entirely;  that  is  to  say,  the  banker  cannot  sell  in  the  discount 
market  an  acceptance  which  is  not  his  by  right  of  purchase. 
Finally,  if  the  bill  is  bought  by  the  banker,  he  may  choose  to 
hold  it  as  an  investment;  then  his  correspondent  will  be  in- 
structed to  retain  it  until  maturity  instead  of  selling  it  in  the 
discount  market.  These  differences  in  procedure  will  receive 
attention  at  the  proper  place. 

42.  Documentary  commercial  bills.  A  commercial  long 
bill  is  the  financing  instrument  of  a  business  transaction.  If 
it  is  taken  by  the  banker  against  an  advance  of  cash  to  the  ex- 
porter, the  banker  is  extending  credit  to  the  end  that  the 
seller  may  receive  his  money  immediately  without  depri\ang 
the  buyer  of  the  convenience  of  postponing  payment.  If 
taken  by  the  banker  for  collection  only,  the  burden  of  the  ad- 
vance falls  upon  the  seller  who  has  parted  wdth  his  goods  on 
credit  of  the  buyer's  promise  to  pay  at  a  future  date.  In 
either  case  the  seller  bears  a  risk  of  loss,  since  the  banker, 
even  though  he  advances  money  to  acquire  the  exporter's 
bill,  will  have  recourse  to  him  as  drawer  of  the  draft  in  case  of 
default  by  the  foreign  customer.  Both  exporter  and  banker, 
therefore,  have  an  interest  in  maintaining  some  control  over 
the  goods  shipped  until  the  buyer  has  made  proper  settlement 
according  to  the  terms  of  sale  —  the  banker,  because  the 
transaction  of  buying  a  commercial  bill  would  otherwise  rest 
merely  upon  the  unsupported  credit  of  the  seller;  the  exporter, 
because,  in  the  absence  of  such  control  over  the  goods  he  has 
sold,  the  transaction  would  be  founded  solely  upon  his  trust 
in  the  foreign  buyer.  The  security  demanded  by  exporter 
and  banker  is  usually  provided  by  attaching  to  the  bill  of  ex- 
change documents  of  such  a  nature  that  the  holder  of  the  bill 
will  retain  ownership  in  the  goods  which  it  represents  until  he 
chooses  to  part  with  the  documents.  When  this  is  done,  the 
documents  will  form  collateral  security  for  the  bill  of  ex- 
change, and  the  resulting  collection  of  instruments  will  com- 
prise a  documentary  commercial  bill.  Nearly  all  commercial 
bills  are  of  this  kind. 


COMMERCIAL  BILLS  168 

To  understand  the  nature  of  these  documents,  it  is  neces- 
sary to  bear  in  mind  that  their  purpose  is  to  vest  in  the  holder 
of  the  bill  of  exchange  ownership  in  the  goods,  and  that  this 
ownership  must  be  transferable  from  one  holder  to  another 
as  the  bill  proceeds  on  its  way  toward  collection.  These 
functions  are  discharged  by  the  following  instruments : 

(1)  The  bill  of  lading  received  by  the  seller  when  the  goods 
are  shipped. 

(2)  The  insurance  certificate  which  will  indemnify  the 
owner  in  case  of  loss  in  transit. 

(3)  The  hypothecation  slip  which  formally  transfers  owner- 
ship in  the  preceding  documents  to  the  holder  of  the 
draft. 

In  the  practice  of  export  trade,  other  documents  are  fre- 
quently attached  to  the  bill  of  exchange  in  addition  to  the 
three  mentioned  above,  such,  for  example,  as  the  commercial 
and  the  consular  invoices,  but  these  are  for  the  convenience 
of  the  importer  and  not  for  the  security  of  the  exporter  or  the 
banker  and,  accordingly,  have  no  bearing  upon  the  subject  in 
hand.  We  shall  now  proceed  to  examine  these  documents  in 
some  detail. 

1.  The  hill  of  lading.  In  foreign  commerce  as  in  domestic, 
the  bill  of  lading  given  by  the  transportation  company  to  the 
shipper  is  both  a  receipt  for  the  goods  shipped  and  a  contract 
of  affreightment.  This  document  must  be  so  drawn  as  to 
describe  the  shipment  accurately,  stating  the  number,  weight, 
contents,  and  identification  marks  of  the  packages.  This 
information  suffices  to  enable  the  bill  of  lading  to  discharge 
its  function  as  a  receipt  for  the  goods  put  aboard  the  steamer. 
To  function  as  a  contract  of  affreightment,  the  bill  of  lading 
must  contain,  in  addition  to  the  information  given  above,  the 
name  of  the  consignee,  the  port  of  destination,  and  the  signa- 
ture of  the  shijjpcr.  When  thus  drawn  up  and  signed  by  the 
transportation  company,  the  carrier  is  bound  by  the  bill  of 
lading  to  deliver  the  goods  at  destination  to  no  other  person 
than  the  one  legally  entitled  to  them. 

Several  copies  of  the  bill  of  lading  are  prepared  for  every 
shipment,  the  exact  number  depending  upon  the  needs  of  the 


101  FOREIGN  EXCHANGE 

exporter,  the  steamship  company,  and  the  consular  author- 
ities. These  duphcates  are  of  two  classes :  negotiable  and  non- 
negotiablc.  The  negotiable  copies,  only,  can  be  used  to  secure 
possession  of  the  goods  on  arrival;  when  properly  endorsed, 
any  one  of  them  gives  a  legal  holder  title  to  the  shipment. 
The  non-negotiable  copies  are  retained  by  the  different  par- 
ties as  a  matter  of  record. 

The  bill  of  lading  may  be  drawn  either  to  the  order  of  the 
shipper,  or  in  the  name  of  the  foreign  buyer;  the  former  is 
called  an  order  bill  of  lading;  the  latter,  a  straight  bill  of  lading. 
This  difference  has  a  significant  effect  upon  the  value  of  the 
bill  of  lading  as  collateral  security  for  the  exporter's  drafts. 
When  the  order  bill  is  drawn,  the  shipper  (exporter)  retains 
ownership  in  the  goods  during  their  transportation,  and  after 
their  arrival,  until  he  is  induced  to  part  with  the  bill  of  lading 
by  endorsement.  By  endorsing  this  order  bill  in  blank  — 
that  is,  making  it  the  legal  property  of  the  bearer  and  trans- 
ferable without  further  endorsement  —  and  attaching  it  to 
his  draft,  the  exporter  will  place  in  the  hands  of  the  bankers 
the  maximum  of  control  over  the  shipment.  The  foreign 
buyer  cannot,  then,  obtain  his  goods  without  inducing  the 
bankers  to  release  a  negotiable  copy  of  the  endorsed  bill  of 
lading,  and  this,  obviously,  the  bankers  will  not  do  until  the 
buyer  has  performed  his  obligations  as  drawee  of  the  ex- 
porter's draft.  The  straight  bill  of  lading  is  not  thus  of  serv- 
ice as  collateral  security  for  the  bill  of  exchange.  When 
drawn  to  the  order  of  the  buyer,  the  bill  of  lading  gives  him 
sole  right  to  receive  the  shipment.  In  this  case,  he  usually 
does  not  need  the  bill  of  lading  to  claim  his  goods;  the  steam- 
ship company  will  inform  him  upon  arrival  of  their  readiness 
to  make  delivery,  and  the  goods  will  be  turned  over  to  him 
upon  his  surrender  of  a  properly  endorsed  notice  of  arrival. 
The  laws  of  some  countries  —  for  example,  Columbia  and 
Venezuela  —  prohibit  the  drawing  of  order  bills  of  lading, 
prescribing  that  the  goods  be  consigned  directly  to  the  im- 
porter. \^Tien,  in  conformity  with  these  laws,  a  straight  bill 
of  lading  is  drawn,  its  possession  by  the  bankers  does  not  add 
to  the  security  of  the  bill  of  exchange,  and  the  bankers,  accord- 


COMMERCIAL  BILLS  165 

ingly,  are  slow  to  negotiate  drafts  thus  secured.  It  is  the 
order  bill  of  lading,  however,  which  is  typical  of  foreign  com- 
merce; in  this  instrument,  the  exporter  and  the  banker  find 
protection  against  loss  from  default  on  the  part  of  the  foreign 
buyer. 

2.  The  insurance  certificate.  The  ocean  carrier,  unlike  the 
domestic  carrier,  is  not  legally  bound  to  make  good  any 
damage  suffered  by  the  shipment  while  in  transit,  unless  the 
damage  results  directly  from  negligence  or  fraud  on  the  part 
of  the  company  or  its  employees.  For  this  reason,  it  is  al- 
ways essential  that  foreign  shipments  be  insured  against  total 
or  partial  loss.  For  our  purpose,  it  is  unnecessary  to  inquire 
into  the  technicalities  of  marine  insurance;  like  the  bill  of 
lading,  the  insurance  certificate  is  usually  made  out  to  the 
order  of  the  shipper,  thus  making  possible  a  transfer  of  the 
claim  to  indemnification  to  each  successive  holder  of  the  bill 
of  exchange.  This  certificate  in  no  wise  improves  the  legal 
title  in  the  goods  which  vests  in  the  holder  of  the  bill  of  lading, 
yet  its  addition  to  the  documents  attaching  to  a  commercial 
long  bill  is  necessary  to  perfect  the  banker's  protection  against 
loss  from  the  transaction.  The  complement  of  order  bill  of 
lading  and  insurance  certificate  reduces  to  a  minimum  the 
risks  involved  in  the  buying  of  commercial  bills  of  exchange, 
defending  the  buyer  as  it  does,  not  only  from  bad  faith  on  the 
part  of  the  drawee  of  the  bill  of  exchange,  but  also  from  the 
hazards  of  marine  transportation. 

3.  The  hypothecation  slip.  To  "hypothecate"  is  to  make 
a  formal  pledge  of  personal  property  as  security  to  a  creditor. 
With  reference  to  the  transaction  we  have  been  considering, 
the  act  of  hypothecation  is  merely  a  formal  declaration  by  the 
shipper  that  it  is  his  intention  to  transfer  legal  title  in  the  bill 
of  lading  and  the  insurance  certificate  to  the  holder  of  the 
draft  which  he  draws  against  his  foreign  customer.  This  act 
of  hypothecation  may  be  performed  separately  each  time  the 
exporter  sells  a  commercial  bill  to  his  banker;  however,  if  the 
former  has  arranged  for  the  financing  of  a  series  of  foreign 
sales,  he  will  pro))al)ly  be  asked  to  sign  a  general  letter  of 
hypothecation.     The  letter  of  hypothecation  is  so  drawn  as 


166  FOREIGN  EXCHANGE 

to  secure  for  the  bankers  the  utmost  possible  protection 
against  loss,  and  the  utmost  freedom  of  action  with  respect 
to  the  shipment  in  the  event  that  such  action  is  necessary  to 
protect  thcii-  interests.  A  tj'pical  letter  contains  the  follow- 
ing {provisions  :^ 

(a)  The  exporter  declares  his  intention  of  delivering  to  the 
banker  a  series  of  bills  of  exchange  with  shipping  docu- 
ments attached,  and  agrees  that  the  letter  shall  have 
the  same  force  with  respect  to  these  documents  as  if  a 
separate  hypothecation  were  made  to  cover  each  trans- 
action. 
(6)  The  conditions  under  which  the  shipping  documents 
are  to  be  delivered  to  the  foreign  buyer  are  carefully 
stated.  It  is  customary  for  the  banker  to  reserve  the 
right  to  make  partial  deliveries  of  goods  under  terms 
satisfactory  to  himself  when  these  conditions  require 
payment  by  the  buyer  before  the  release  of  the  shipping 
documents. 

(c)  The  exporter  agrees  to  provide  suitable  insurance  for 
each  shipment;  failing  this,  the  banker  is  empowered 
to  take  out  the  insurance  and  charge  its  cost  to  the  ex- 
porter. Insurance  is  to  be  fh  the  name  of  the  banker 
and  for  his  benefit  in  case  of  loss.  But  any  loss  not 
covered  by  the  insurance  policy  is  to  be  paid  by  the 
exporter. 

(d)  The  procedure  in  case  of  default  by  the  importer  is 
carefully  outlined.  Ordinarily,  the  banker  is  instructed 
to  protest  the  bill  of  exchange  for  non-acceptance  and 
for  non-payment,  and  the  exporter  agrees  to  pay  to  the 
banker  the  amount  of  the  bill  upon  first  notice  of  pro- 
test, together  with  all  costs  and  charges. 

(e)  Wide  powers  are  given  the  banker  and  his  agents  to 
seize  the  goods.  Seizure  may  occur  because  of  non- 
acceptance  or  non-payment  by  the  importer,  or  be- 
cause of  bankruptcy  or  failure  by  the  importer,  or  for 
any  other  reason  which,  in  the  opinion  of  the  banker, 
excuses  the  seizure  as  a  protective  measure.    The  goods 

^  See  form  8,  pages  I68-69. 


COMIVIERCIAt.  BILLS  167 

when  seized  are  to  be  sold  by  the  banker  directly  or 
through  a  broker,  and  the  proceeds  of  the  sale  to  be 
applied  to  the  replacement  of  the  funds  advanced  to 
the  exporter  through  the  purchase  of  the  bill  of  ex- 
change.    All  costs,  fees,  commissions,  etc.,  in  connec- 
tion with  the  seizure  and  sale,  are  to  be  charged  to  the 
exporter.     It  is  also  specifically  stated  that  this  pro- 
cedure in  no  way  releases  the  exporter  from  his  liability 
as  drawer  of  the  bill  of  exchange. 
(/)  The  banker  reserves  the  right  to  call  for  additional  col- 
lateral security,  of  any  form  satisfactory  to  him,  in  case 
there  is  danger  of  loss  for  any  reason. 
(g)  The  banker  is  not  to  be  held  responsible  for  any  de- 
fault by  broker  or  other  agent  employed  by  him  in  con- 
nection with  the  seizure  and  sale  of  the  goods. 
(h)  A  general  clause  is  inserted  in  the  letter  to  the  effect 
that  no  event,  other  than  a  satisfactory  redemption  of 
the  bill  of  exchange,  shall  release  the  exporter  from  his 
liability  to  the  banker,  or  other  holder  of  the  bill,  arising 
from  his  position  as  drawer. 
(i)  The  letter  is  made  terminable  upon  notice  by  the  ex- 
porter. 
43    Documentary    instructions.    The    completed    docu- 
mentary bill  is,  therefore,  a  small  bundle  of  instruments  se- 
curely fastened  together  so  that  they  cannot  become  sep- 
arated in  the  mails,  comprising  (1)  the  exporter's  draft  for 
the  value  of  the  goods  shipped;  (2)  the  bill  of  lading,  usually 
drawn  to  order  and  endorsed  in  blank,  whose  possession 
bestows  legal  right  to  claim  the  shipment  at  destination;  (3) 
in  the  absence  of  a  general  letter  of  hypothecation,  an  hypoth- 
ecation slip  which  formally  pledges  the  shipping  documents 
as  collateral  to  the  banker  who  handles  the  bill  of  exchange. 
To  govern  the  bankers  in  their  handling  of  the  trans- 
action, the  exporter  usually  adds  a  set  of  instructions  at  the 
time  the  bill  is  placed  in  the  banker's  hands.    Because  of  the 
distance  which  separates  the  markets  and  the  oi)portunities 
for  misunderstandings  to  arise,  it  is  exceedingly  important  to 
the  drawer  of  the  bill  that  these  instructions  be  sufficiently 


1C8  FOREIGN  EXCHANGE 

Form  8.  General  Letter  of  IIypotiiecation 

To  the  Hongkong  and  Shanghai  Banking  Corporation. 

As  you  may  from  time  to  time  purchase  from  or  negotiate  for  mc/us  Bill  or 
Bills  of  Exchange  drawn  or  endorsed  by  me/us  with  collateral  securities,  it  has 
been  agreed  betwtH*n  us  that  the  stipulations  contained  in  tliis  Memorandum 
shall  Im?  dcemeil  to  be  continuing  and  ambulatory,  and  are  to  af)ply  to  all 
cases  in  which  such  Bills  of  Exchange  may  at  any  time  either  directly,  or 
through  other  persons,  be  negotiated  with  or  sold  to  you  by  me/us  and  this 
Memorandum  shall  have  the  same  force  until  I/we  shall  give  you  notice  of 
my/ our  mtention  to  terminate  it,  as  if  a  separate  Memorandum  were  signed 
by  me/ us  on  each  purchase  or  negotiation. 

I/we  authorize  you,  or  any  of  your  Managers,  or  Agents,  or  the  Holders  for 
the  time  being,  of  any  such  Bill  or  Bills  as  aforesaid  (but  not  so  as  to  make  it 
imperative)  to  insure  any  goods  forming  the  collateral  security  for  any  such 
Bill  or  Bills  of  Exchange  from  sea  risk,  including  loss  by  capture,  and  also 
from  loss  by  fire  on  shore,  and  to  add  the  premiums  and  expenses  of  such  in- 
surances to  the  amount  chargeable  to  me/us  in  respect  of  such  Bill  or  Bills, 
and  to  take  recourse  against  such  goods  in  priority  to  any  other  claims 
thereon,  or  against  me/us,  without  prejudice  to  any  claim  against  any  en- 
dorser or  endorsers  of  the  said  Bills,  for  reimbursing  yourselves,  or  other  the 
person  or  persons  paying  the  same,  the  amount  of  such  premiums  and  ex- 
penses, and  also  to  sell  any  portion  of  such  goods  which  may  be  necessary  for 
payment  of  freight,  insurance,  and  expenses,  and  generally  to  take  such 
measures  and  make  such  charges  for  commission,  and  to  be  accountable  in 
such  manner,  but  not  further  or  otherwise  than  as  in  ordinary  cases  between  a 
merchant  and  his  correspondent.  And  I/we  consent  to  the  goods  being 
warehoused  at  any  public  or  private  wharf  or  warehouse  selected  by  the 
Drawees  or  Acceptors  of  the  Bills,  unless  you  offer  an  objection  to  such  wharf 
or  warehouse. 

I/we  hereby  authorize  you,  or  any  of  your  Managers,  or  Agents,  or  the 
Holders  for  the  time  being  of  any  Bill  or  Bills  of  Exchange  as  aforesaid,  to 
take  conditional  acceptances  to  all  or  any  of  such  Bills,  to  the  effect  that,  on 
payment  thereof  at  maturity,  the  Documents  handed  to  you  as  collateral 
security  for  the  due  payment  of  any  such  Bill  or  Bills  shall  be  delivered  to  the 
Drawees  or  Acceptors  thereof,  and  such  authorization  shall  be  taken  to  ex- 
tend to  cases  of  acceptance  for  honour.  Subject  nevertheless  to  the  power 
next  hereinafter  given,  in  case  the  Drawee  shall  suspend  payment,  become 
bankrupt,  or  go  into  liquidation  during  the  currency  of  any  such  Bill  or  Bills. 

I/we  further  authorize  you  at  any  time  or  times  before  the  maturity  of  any 
Bill  or  Bills  of  Exchange,  as  aforesaid,  to  grant  a  partial  delivery  or  partial 
deliveries  from  time  to  time  of  any  part  or  parts  of  such  goods,  in  such  man- 
ner as  you  or  the  Acceptors  of  such  Bill  or  Bills  of  Exchange,  or  their  repre- 
sentatives may  think  desirable  to  any  person  or  persons  on  payment  of  a 
proportionate  amount  of  the  invoice  cost  of  such  goods,  or  of  the  Bill  or  Bills 
of  Exchange  drawn  against  same. 

I/we  further  authorize  you,  or  any  of  your  Managers,  or  Agents,  or  the 
Holders  for  the  time  being  of  any  Bill  or  Bills  of  Exchange  as  aforesaid,  on 
default  being  made  in  acceptance  on  presentation,  or  in  payment  at  maturity, 
of  any  of  such  Bill  or  Bills,  or  in  case  of  the  Drawees  or  Acceptors  suspending 
payment,  becoming  bankrupt,  or  entering  into  liquidation  during  the  cur- 
rency of  any  such  Bill  or  Bills,  and  whether  accepted  conditionally  or  abso- 


COMMERCIAL  BILLS  169 

lutely,  to  sell  all,  or  any  part  of  the  goods  forming  the  collateral  security  for 
the  pa>Tnent  thereof  at  such  times  and  in  such  manner  as  you,  or  such  Hold- 
ers may  deem  fit,  and,  after  deducting  usual  commission  and  charges,  to 
apply  the  net  proceeds  in  payment  of  such  Bill  or  Bills  with  re-exchange  and 
charges;  the  balance,  if  any,  to  be  placed  at  your  option  against  any  other 
of  my/our  Bills,  secured  or  otherwise,  which  may  be  in  your  hands,  or  any 
other  debt  or  liability  of  mine/ ours  to  you,  and  subject  thereto,  to  be 
accounted  for  to  the  proper  parties. 

In  case  the  net  proceeds  of  such  goods  shall  be  insufficient  to  pay  the 
amount  of  any  such  Bill  or  Bills,  with  re-exchange  and  charges,  I/we  author- 
ize you,  or  any  of  your  Managers,  or  Agents,  or  the  Holders  for  the  time  being 
of  such  Bill  or  Bills  as  the  case  may  be  to  draw  on  me/ us  for  the  deficiency, 
without  prejudice  nevertheless  to  any  claim  against  any  endorser  or  endorsers 
of  the  said  Bills  for  recovery  of  the  same  or  any  deficiency  on  the  same;  and 
I/we  engage  to  honour  such  Drafts  on  presentation,  it  being  understood  that 
the  Account  Current  rendered  by  you  or  by  such  Holders,  shall  be  suflScient 
proof  of  sale  and  loss. 

I/we  further  authorize  you,  or  any  of  your  Managers,  or  Agents,  or  the 
Holders  for  the  time  being  of  any  such  Bill  or  Bills  as  aforesaid,  whether  the 
aforesaid  Power  of  Sale  shall  or  shall  not  have  arisen  at  any  time  before  the 
maturity  of  any  such  Bill  or  Bills,  to  accept  payment  from  the  Drawees  or 
Acceptors  thereof,  if  required  so  to  do,  and  on  payment  to  deliver  the  Bills  of 
Lading  and  Shipping  Documents  to  such  Drawees  or  Acceptors;  and,  in  that 
event,  you  or  the  Holders  of  any  such  Bill  or  Bills  are  to  allow  a  discount 
thereon,  not  exceeding  per  cent,  per  annum  for  the  time  they 

may  have  to  run  as  follows: 

At  one  half  per  cent,  per  annum  above  the  advertised  rate  of  interest  for 
short  deposits  allowed  by  the  leading  London  Joint  Stock  Banks,  if  pay- 
able in  Great  Britain. 

At  the  current  minimum  rate  of  discount  of  the  National  Banks  of  France, 
Italy  and  Belgium,  if  payable  in  those  countries. 

At  the  current  rate  of  rebate  for  Documentary  Bills,  if  payable  in  Ger- 
many, Switzerland  or  the  United  States. 

At  the  current  rate  of  rebate  allowed  by  the  Exchange  Banks,  if  payable  at 
any  place  east  of  Suez. 

The  delivery  of  such  collateral  securities  to  you  shall  not  prejudice  your 
rights  on  any  of  such  Bill  or  Bills  in  case  of  dishonour,  nor  shall  any  recourse 
taken  thereon  affect  your  title  to  such  securities  to  the  extent  of  my/our 
liability  for  the  time  being  to  you  as  above,  and  it  is  agreed  that  you  are  not 
to  be  responsible  for  the  default  of  any  Broker  or  Auctioneer  employed  by 
you  for  any  purpose. 

Dated this day  of 

One  Thousand  Nine  Hundred  and 


Witness  to  the  Signature  of. 


• . .  Witness 
.Occupation 
. . .  Address 


170  FOREIGN  EXCHANGE 

definite  and  comprehensive  to  inform  the  bankers  of  the  pro- 
cedure to  be  followed  in  the  event  of  certain  contingencies 
^\llich  affect  the  drawer's  interests.  Snch  instructions  are 
especially  necessary  when  the  bill  is  not  sold  to  the  banker, 
but  placed  in  his  hands  for  collection;  for  then  the  banker  acts 
merely  as  an  agent  for  the  drawer  and  does  not  desire  broad 
discretionary  powers.  In  all  cases,  however,  the  drawer  of 
the  bill  bears  a  credit  risk  which  should  impel  him  to  provide 
with  care  against  misunderstanding  or  bad  faith  on  the  part 
either  of  the  foreign  customer  or  of  the  bankers  through 
whose  hands  the  bill  passes. 

It  is,  of  course,  impracticable  in  a  book  of  this  nature  to 
attempt  a  complete  description  of  these  instructions  in  all 
their  possible  varieties.  The  drawer  must  be  governed  in 
each  instance  by  the  nature  of  the  transaction,  the  business 
practice  of  the  foreign  market  concerned,  and  the  character 
and  responsibility  of  his  foreign  customer.  The  problem, 
however,  is  of  sufficient  practical  importance  to  business  men 
who  have  to  do  with  foreign  bills  that  its  general  character- 
istics should  be  considered.  There  are  certain  contingencies 
of  major  importance  which  should  without  fail  be  covered  by 
the  documentary  instructions.     These  are: 

(a)  A  request  from  the  drawee  for  an  extension  of  time  in 
which  either  to  accept  or  to  pay  the  bill  of  exchange. 

(b)  A  request  from  the  drawee  for  a  surrender  of  the  bill  of 
lading  at  an  earlier  date  than  that  fixed  by  the  terms  of 
the  bill  of  exchange. 

(c)  An  absolute  refusal  by  the  drawee  to  honor  the  bill  at 
acceptance  or  at  maturity. 

The  drawee's  request  for  an  extension  of  the  date  of  accept- 
ance is  usually  based  upon  the  fact  that  the  goods  have  not 
arrived  and  that,  consequently,  no  examination  is  possible  to 
assure  the  buyer  of  the  seller's  discharge  of  his  duties  in  con- 
formity with  the  terms  of  sale.  Extension  of  payment  is  usu- 
ally requested  when  the  condition  of  the  drawee's  business  is 
temporarily  such  as  to  make  prompt  payment  burdensome, 
or  when  the  state  of  the  exchange  market  is  seriously  adverse 
to  the  drawee.     In  both  cases,  it  might  well  be  that  the 


COMMERCIAL  BILLS  171 

drawer  of  the  bill  of  exchange,  if  he  were  on  the  ground  and 
could  discuss  the  matter  with  the  drawee,  would  concede  the 
reasonableness  of  the  request  and  be  willing  to  grant  it.  But 
the  hanker  has  power  to  make  these  extensions  only  if  au- 
thority has  been  given  him  by  the  drawer,  explicitly  or  by  im- 
plication, to  exercise  his  judgment  in  the  matter.  In  the 
absence  of  such  instructions,  the  banker  can  act  only  at  the 
risk  of  releasing  the  drawer  from  his  liability  by  reason  of  the 
fact  that  he,  the  banker,  exceeded  his  powers.  Consequently, 
if  the  instructions  touching  this  point  are  absent  or  vague,  the 
result  is  apt  to  be  a  rigid  enforcement  by  the  banker  of  the 
terms  of  the  bill  of  exchange  which  may  injure  the  good-will 
of  the  foreign  customer  toward  the  exporter. 

We  are  not  at  this  point  prepared  to  discuss  the  conditions 
which  govern  the  surrender  of  the  bill  of  lading  to  the  drawee 
of  the  bill  of  exchange.  This  matter  will  be  taken  up  at 
length  in  the  sections  which  follow.  It  should  be  made  clear, 
however,  that  the  drawer  must  not  rely  upon  the  banker  to  dis- 
regard the  terms  of  release  of  the  bill  of  lading  stated  on  the 
draft,  no  matter  how  reasonable  the  drawee's  request  and 
how  willing  the  drawer  to  accede  to  it,  unless  appropriate 
instructions  have  been  given  the  banker.  For  in  this  case, 
also,  the  banker  can  act  on  his  own  initiative  only  by  run- 
ning the  risk  of  the  drawer's  demanding  release  from  his  lia- 
bility on  the  plea  of  improper  behavior  by  the  banker. 

The  question  which  arises  in  the  event  of  the  drawee's  re- 
fusal to  accept  or  to  pay  is  usually  whether  to  protest  the 
draft.  The  value  of  the  protest  to  the  drawer  of  the  bill  varies 
with  the  laws  of  different  countries.  Under  the  Si)anish  law, 
which  includes  the  law  of  Spanish-American  republics,  the 
protest  makes  possible  speedy  executive  action  and  the  re- 
covery of  damages  by  attachment  of  the  drawee's  assets, 
whereas,  otherwise,  a  long  and  expensive  civil  suit  would  be 
necessary.  In  Anglo-Saxon  law,  its  chief  value  is  in  the 
proof  which  it  gives  that  dishonor  has  actually  occurred. 
From  the  point  of  view  of  the  banker,  the  act  of  protest  has  a 
different  significance;  for,  unless  the  documentary  instruc- 
tions specifically  waive  protest,   f«''urc  to  protest  a  dis- 


17^  FOREIGN  EXCILVNGE 

honorod  draft  within  tlie  time  limit  set  by  the  law  releases 
all  parties  secoiularily  liable  —  including  the  endorsers  and 
the  drawer.  The  banker,  therefore,  will  never  fail  to  protest 
unless  authorized  to  refrain  from  doing  so.  Nevertheless, 
occasions  arise  when  it  would  be  to  the  drawer's  interest  as  an 
exporter  of  goods  to  forego  the  right  of  protest,  and  when  he 
would  be  willing  so  to  instruct  the  banker  if  the  facts  w'ere 
known  to  him.  Hence,  to  avoid  misunderstanding,  the  docu- 
mentary instructions  should  give  the  banker  a  qualified  power 
to  waive  protest  or  else  should  make  a  specific  demand  for 
protest  under  all  conditions. 

One  of  the  largest  banks  in  New  York  states  its  request  for 
instructions  from  its  cHents  in  the  following  form: 

Advise  us  whether  the  draft  is  to  be  protested  in  case  of  non- 
acceptance  or  non-payment.  Also  state  whether  you  wish  cable 
advice  of  non-acceptance  or  non-payment. 

Be  specific  as  to  instructions  regarding  the  surrender  to  the 
drawee  of  the  shipping  documents  covering  the  goods  for  which  the 
drafts  are  drawn;  that  is,  whether,  in  the  event  of  the  draft  being  a 
time  draft,  such  bills  of  lading  and  other  documents  are  to  be  sur- 
rendered upon  acceptance  or  upon  pa^Tnent.  The  absence  of  defi- 
nite instructions  in  this  respect  renders  necessary  cabling  to  New 
York  for  instructions  with  the  consequent  expense. 

Firms  having  agents  or  representatives  in  the  foreign  field  should, 
likewise,  inform  the  bank  of  the  precise  powers  delegated  to  such 
representatives,  in  order  that  the  bank  may  know  just  how  far  it  is 
to  accept  instructions  regarding  any  question  which  may  arise  on 
collection  items.  If  it  is  intended  to  confer  power  on  the  agent  or 
representative  to  demand  documents  of  the  correspondent  bank,  to 
dispose  of  or  reship  the  goods  in  event  of  non-payment,  etc.,  or  to 
extend  time  on  disputed  drafts,  such  authority  should  be  incorpo- 
rated in  a  regular  power  of  attorney.  A  copy  of  such  power  should 
be  deposited  with  this  bank  to  be  forwarded  to  our  foreign  branches 
and  correspondents. 

In  the  absence  of  a  duly  appointed  agent  at  destination,  it  is  ad- 
visable to  leave  to  the  discretion  of  our  branch  manager  the  steps  to 
be  taken  on  uncollected  items.  Where  definite  instructions  to  pro- 
test are  received,  the  instructions  will,  of  course,  be  followed,  al- 
though in  many  cases  the  protest  of  an  uncollected  item  is  unjust  to 


COMMERCIAL  BILLS  173 

the  foreign  drawee,  particularly  where  the  merchandise  has  not  yet 
arrived,  or  has  arrived  in  bad  condition,  or  is  not  what  was  ordered. 
If  this  matter  of  protest,  however,  be  left  to  the  discretion  of  the 
branch  manager  or  correspondent,  the  transaction  may  be  adjusted 
amicably  without  recourse  to  this  procedure.  The  instruction,  "no 
protest,"  should  never  be  given,  as  the  branch  manager  or  corre- 
spondent is  thus  estopped  from  using  this  leverage  to  compel  pay- 
ment should  circumstances  render  such  action  advisable. 

When  required,  the  bank  will  endeavor  to  dispose  of  merchandise 
on  uncollected  items,  employing  the  services  of  a  local  broker  for 
this  purp)ose. 

An  examination  of  these  instructions  will  show  that  they 
are  intended  to  apply  chiefly  to  "collection  items,"  with  re- 
gard to  which  the  banker  acts  as  agent  of  the  drawer  and  can 
act  only  to  the  extent  of  the  authority  bestowed  upon  hira, 
and  in  the  manner  required  by  the  drawer.  The  events  con- 
cerning which  the  banker  chiefly  expresses  desire  to  receive 
explicit  instruction  are  those  of  dishonor  by  the  drawee  of  the 
bill  of  exchange  —  either  non-acceptance  or  non-payment. 
He  must  know  whether  or  not  to  protest  the  bill,  and  if  so, 
whether  or  not  to  postpone  protest  in  case  the  drawee  has  a 
reasonable  excuse  for  non-performance  of  his  duty.  The 
expenses  of  protest,  sometimes  rather  heavy,  must  be  borne 
by  the  drawer,  who,  also,  must  bear  the  risk  of  losing  the 
patronage  of  his  customer  in  case  the  latter  is  offended  by  the 
action.  How  to  dispose  of  the  goods  in  case  of  an  uncollected 
item  is  also  a  matter  requiring  definite  understanding  be- 
tween banker  and  exporter.  These  goods  belong  to  the  ex- 
porter; they  may  be  sold  at  public  or  private  sale,  or  turned 
over  to  a  local  agent  for  distribution  among  other  customers 
in  the  same  market,  or  reshipped  to  another  port.  The  banker 
cannot  proceed  in  any  of  these  matters  further  than  his  in- 
structions warrant;  if  he  does  so,  he  becomes  responsible  to 
the  exporter  and  can  be  made  to  bear  any  loss  arising  from  his 
conduct.  In  view  of  this  risk,  the  banker  may,  in  the  ab- 
sence of  instructions,  cable  for  advice  at  the  exporter's  expense, 
which  will  increase  the  costs  of  the  transaction.  Banks  fre- 
quently supply  their  clients  with  printed  blanks  to  be  filled 


174 


FOREIGN  EXCHANGE 


out  and  attached  to  the  other  documents  which  accompany 
a  collection  bill  of  exchange.  The  following  is  an  example  of 
one  of  these  blanks: 

THE  FmST  COMMERCIAL  BANK  OF  NEW  YORK 

Dear  Sirs: 

AVe  enclose  for  collection  the  undermentioned  draft  with  docu- 
ments as  enumerated.  The  surrender  of  documents  to  drawee  is 
conditional  upon  the  fulfillment  of  instructions  as  indicated  by  cross 
( X )  in  margin. 


Draft 


Number 


Documents 


Number 

Drawer 

Drawee 

AMiere  payable. 
Date  payable .  . 

Amount 

Drawn  at 


Commercial  Invoice 
Consular  Invoice 
Bills  of  Lading 
Insurance  Certificate 
Certificate  of  Origin 
Weight  Certificate 
Declaration  of  Shipper 


Instmctiov 

Documents  against    Acc'S^t^ce 

T,    .     .   i        Non-Pa\Tnent 
l^rotest  for    t.^       *   "      . 

JN  on- Accei>tance 

Permit  the  drawee  privilege  of  inspecting  the  goods  before  ac- 
cepting. 

Hold  for  arrival  of  goods. 

Payable  at  collecting  bank's  selling  check  rate  on  New  York. 

Payable  at  check  rate  on  New  York,  remitting  proceeds  by  cable, 
charges  for  our  account.  . 

Interest  to  be  collected  at from  date  of  issue  until  ap- 
proximate arrival  of  funds  in  New  York. 

Allow  drawee  interest  at i>er  annum  for  anticipated 

payment. 


COMMERCIAL  BILLS  175 

All  charges  for  account  of  ^^ 

Waive  charges  if  refused  by  drawee. 

In  case  of  need  refer  to    and  advise  im- 
mediately by  cable. 

Kindly  collect  this  draft  through 

(Signed) 

The  bundle  of  instruments  which  comprises  a  documen- 
tary bill  of  exchange  is  usually  made  out  in  duplicate  or  tripli- 
cate, the  whole  collection  being  known  as  a  complete  set  of  bills. 
This  practice,  very  probably,  arose  when  the  uncertainties  of 
ocean  mail  made  it  advisable  to  send  the  drafts  forward  by 
dijfferent  steamers,  thus  reducing  the  risk  of  non-arrival.  It  is 
continued  largely  because  it  gives  the  banks  useful  docu- 
ments of  record  as  a  check  upon  the  transaction.  Also  the 
duplicate  bills  are  put  to  technical  uses  when  the  banker  buys 
the  exporter's  draft  for  investment.^  In  ordinary  practice 
one  of  the  duplicate  bills  of  exchange  is  attached  to  each 
set  of  shipping  documents  and  is  stamped,  in  order  of  draw- 
ing, first  of  exchange,  second  of  exchange,  third  of  exchange. 
The  wording  of  each  of  the  bills  shows  that  it  is  a  conditional 
order,  payable  only  in  event  that  none  of  the  others  has  been 
paid.     Thus  the  first  of  exchange  will  read: 

Pay  to  the  order  of  ,  second  and 

third  unpaid. 

And  the  second  will  read: 

Pay  to  the  order  of ,  first  and  third 

unpaid. 

Payment  of  one  of  these  drafts  is  sufficient  to  render  all  the 
others  void  and  to  relieve  the  drawee  of  further  ol)ligation; 
however,  the  one  upon  which  payment  is  effected  may  le- 
gally be  any  one  of  the  duplicates,  and  not  necessarily  the  first 
of  exchange. 

»  See  Section  67. 


170  FOREIGN  EXCHANGE 

44.  Documentary  acceptance  bills.  AVhon  the  documen- 
tary bill  is  the  huiuicing  instrument  of  a  commercial  trans- 
action, the  imi)orter  cannot  obtain  his  goods  until  he  has  so 
far  discharged  his  obligations  under  the  terms  of  sale  as  to 
induce  the  holder  of  the  bill  of  exchange  to  release  the  bill  of 
lading  and  other  shipping  documents.*  Whether  these  docu- 
ments will  be  released  upon  acceptance,  or  be  held  until  pay- 
ment, is  one  of  the  details  of  the  transaction  covered  by  the 
agreement  between  the  two  merchants.  However,  the  mer- 
chants do  not  have  unqualified  freedom  of  choice  in  this 
matter.  Obviously,  the  exporter  will  be  concerned,  if  he 
plans  to  sell  his  bill  of  exchange,  not  to  accept  such  terms  as 
will  limit  the  market  for  his  bill,  for  a  ready  negotiation  of  the 
bill  will  be  as  essential  to  his  profit  as  is  the  sale  of  his  goods. 
When  the  terms  call  for  delivery  of  the  shipping  documents 
against  acceptance,  all  collateral  disappears  before  the  draft 
is  collected,  and  the  acceptance  which  remains  in  the  hands  of 
the  banker  will  rest  merely  upon  the  credit  of  the  two  parties 
—  drawee  and  drawer.  The  exporter  will  find  it  more  diffi- 
cult to  obtain  an  advance  of  funds  upon  such  a  bill  because 
of  the  temporary  nature  of  the  collateral;  indeed,  if  the  bill 
is  a  trade  bill,^  his  banker  will  very  probably  either  refuse  to 
negotiate  it  or  will  demand  the  deposit  of  some  other  form  of 
collateral  security.  When  the  banker  does  agree  to  purchase 
such  a  bill,  it  is  because  of  his  confidence  in  the  good  faith  of 
the  acceptor,  or  of  the  very  high  credit  rating  of  the  drawer, 
or  for  both  of  these  reasons.  So  it  happens  that  when  the 
importing  merchant  has  engaged  the  services  of  a  banker  as 
the  acceptor  of  the  bill,  documents  will  always  be  delivered 
against  acceptance,  the  credit  standing  of  a  bank  being  suffi- 
ciently high  to  make  good  the  lack  of  collateral.  Also  a  small 
number  of  mercantile  houses  of  high  reputation  are  able  to 
instruct  their  foreign  creditors  to  draw  bills  of  this  kind  upon 
them  directly  with  the  assurance  that  the  bankers  of  the 
exchange  market  will  not  refrain  from  financing  the  trans- 

^  Recall,  in  this  connection,  the  difference  between  the  order  and  the  straight 
bill  of  lading.   See  page  164. 
^  See  definition,  page  91. 


COMMERCIAL  BILLS  IT? 

action.  When  the  act  of  acceptance  is  sufficient  to  give  the 
importer  possession  of  the  goods,  the  bill  of  e.  change  is  given 
the  name,  documentary  acceptance  bill  (abbreviated  D.A.). 

The  superiority  of  the  documentary  acceptance  bill  from 
the  point  of  view  of  the  importer  should  be  apparent.  It 
enables  him  to  gain  possession  of  his  goods  thirty,  sixty,  or 
ninety  days  before  he  is  required  to  pay  for  them.  In  many 
cases,  these  intervals  of  time  are  sufficient  to  permit  the  con- 
clusion of  the  transaction  for  which  the  goods  were  bought; 
that  is,  if  the  importer  is  a  commission  merchant,  the  goods 
may  be  resold  before  the  draft  falls  due;  if  a  manufacturer,  the 
finished  product  may  be  turned  out  and  passed  on  to  the 
wholesaler  or  jobber.  When  the  goods  pass  in  this  manner 
through  the  hands  of  the  importer  during  the  interval  which 
elapses  between  acceptance  and  payment,  the  transaction  is 
practically  self-financing,  since  the  proceeds  of  the  sale  will 
be  in  hand  to  meet  the  cost  of  buying  before  the  draft  ma- 
tures. This  is  one  reason  why  the  bankers'  acceptance  has 
attained  such  widespread  use  in  international  trade.  The 
best  established  importers  frequently  make  arrangements 
with  a  bank  or  finance  house  to  accept  the  drafts  drawn  by 
the  foreign  sellers,  finding  the  greater  convenience  of  the 
documentary  acceptance  bill  sufficient  to  warrant  the  pay- 
ment of  a  commission  to  the  banker  for  this  service.  Until 
recently,  this  practice  was  unknown  in  the  American  market, 
partly  because  of  a  lack  of  knowledge  of  its  merits  and  partly 
because  of  a  weakness  of  the  banking  laws;  but  in  late  years, 
and  especially  since  the  beginning  of  the  Great  War,  the  ac- 
ceptance of  bills  by  American  bankers  for  the  account  of  im- 
porters has  been  growing  rapidly  and  along  with  its  growth 
has  come  an  increase  in  the  number  of  documentary  ac- 
ceptance bills  drawn  against  our  imports. 

It  should  be  noted  further  that  the  choice  of  the  docu- 
mentary acceptance  bill  is  determined  to  some  extent  by  the 
nature  of  the  merchandise  of  which  the  shipment  is  composed. 
When  the  bill  of  lading  is  to  be  surrendered  only  against  the 
payment  of  the  bill  of  exchange,  some  arrangement  must  be 
made  to  care  for  the  goods  between  the  time  of  their  arrival 


178  FOREIGN  EXCHANGE 

and  the  date  of  payment,  an  interval  which  may  extend 
sixty  days  or  lon<;er.  In  the  next  section  we  shall  discuss  the 
methods  adopted  for  the  storage  of  goods  in  such  cases,  but  it 
may  be  remarked  at  this  point  that  not  all  wares  are  of  such 
nature  as  to  permit  of  extended  storage  without  deterioration. 
Grain  may  be  held  for  a  long  time  without  loss  of  quality, 
and  so  we  find  that  the  larger  share  of  our  wheat  bills  are 
drawn  documents  against  payment.  But  fruits,  drugs, 
chemicals,  foodstuffs,  and  many  other  wares  cannot  be  held 
for  extended  periods  without  deterioration.  The  importer 
of  such  goods  attempts  to  provide  an  acceptance  of  such 
quality  that  his  foreign  creditor  may  arrange  terms  of  sale 
calling  for  the  drawing  of  acceptance  drafts.  Sterling  cotton 
bills  in  America  are  almost  universally  acceptance  bills, 
though  this  is  true,  probably,  not  so  much  because  of  the  na- 
ture of  the  commodity  as  because  of  the  high  standing  of  the 
Lancashire  importers  and  their  custom  of  providing  bankers' 
acceptances. 

45.  Documentary  pajmient  bills.  The  term  documentary 
payment  bill  (abbreviated  D.P.)  is  applied  to  the  commercial 
long  bill  whose  documents  will  be  released  only  upon  payment 
by  the  drawee.  What  has  been  said  above  concerning  the 
factors  which  determine  the  choice  of  an  acceptance  bill  w^ill 
apply,  also,  to  the  choice  of  a  payment  bill.  The  nature  of 
the  bill  will  result,  in  the  first  instance,  from  the  terms  of  sale 
concluded  between  the  two  merchants,  but  these  terms  will  be 
dictated,  in  part,  by  the  banker  upon  whom  the  exporter  de- 
pends for  aid  in  financing  the  transaction.  It  is  the  practice 
of  banks  to  require  payment  bills  in  the  case  of  most  drafts 
drawn  by  merchants  upon  other  merchants  in  order  to  reen- 
force  the  acceptance  wath  collateral  security  in  the  form  of  a 
lien  upon  the  goods  which  figure  in  the  transaction.  Hence,  it 
may  be  said  that  the  standard  form  of  trade  acceptance  is 
drawn  to  prevent  the  importer  from  gaining  possession  of  the 
merchandise  until  he  has  paid  the  bill,  or,  at  least,  has  made 
some  arrangement  for  payment  more  satisfactory  than  mere 
acceptance. 

Now,  some  markets  are  so  distant  from  the  export  point 


COMMERCIAL  BILLS  179 

that  the  difference  in  time  required  by  mail  and  freight 
steamers  is  sufficient  to  allow  the  acceptance  to  run  to  ma- 
turity before  the  arrival  of  the  goods,  though  both  are  dis- 
patched at  the  same  time.  For  example,  the  American  im- 
porter of  raw  silk  from  the  Orient  may  find  that  a  draft 
drawn  against  the  shipment  will  arrive  so  far  in  advance  of 
the  freight  steamer  that  the  time  between  acceptance  and 
maturity  will  elapse  before  the  silk  reaches  New  York.  When 
such  is  the  case,  the  disadvantage  of  the  payment  as  com- 
pared with  the  acceptance  draft  is  negligible,  since  the  latter 
could  not  in  any  case  hasten  the  delivery  of  the  goods  to  the 
importer.  This,  however,  is  the  exception  to  the  rule  in 
international  trade.  It  much  more  frequently  happens  that 
the  goods  arrive  many  days  before  the  payment  date  of  the 
draft,  and  the  importer  is  prevented  from  gaining  possession 
of  them  because  of  the  retention  of  the  bill  of  lading  by  the 
banker.  In  this  event,  the  importer,  provided  he  does  not 
wish  to  wait  until  the  maturity  of  his  draft  before  obtaining 
the  goods,  may  have  recourse  to  one  or  the  other  of  two  ex- 
pedients: (1)  an  arrangement  with  the  banker  which  will 
relax  the  terms  of  the  bill  of  exchange  and  allow  delivery  of 
the  goods  before  payment;  (2)  prepayment  of  his  acceptance 
before  maturity. 

In  explanation  of  the  first  of  these  alternatives,  it  should  be 
recalled  that  when  a  banker  buys  the  exporter's  bill  of  ex- 
change, he  is  the  party  primarily  interested  in  retaining  col- 
lateral security  until  the  acceptance  is  paid;  any  arrangement 
which  this  banker  chooses  to  make  regarding  the  surrender  of 
the  bill  of  lading  will,  probably,  not  meet  with  opposition 
from  the  exporter.  In  fact,  the  letter  of  hypothecation  which 
transfers  to  the  banker  the  exporter's  lien  upon  the  shipment 
frequently  provides  in  express  terms  that  the  banker  shall  be 
free  to  surrender  the  bill  of  lading  at  his  discretion.  The  im- 
porter, however,  does  not  deal  directly  with  this  banker,  but 
with  his  foreign  representative  and  the  degree  of  difficulty 
with  which  he  meets  in  an  attempt  to  gain  possession  of  the 
bill  of  lading  will  depend  upon  his  standing  as  a  client  of  this 
foreign  representative  and  also  to  some  extent  upon  the  cus- 


180  FOREIGN  EXCHANGE 

torn  of  his  market.  The  foreign  representative,  it  must  be 
remembered,  is  not  the  owner  of  the  accej)tance,  but  the  agent 
of  the  owner,  and  is  presumably  bound  by  the  instructions  of 
his  principal.  Because  of  a  settled  business  custom  governing 
the  tyi)e  of  merchandise  which  has  been  shipped,  or  because 
of  the  high  standing  of  the  importer,  the  banker  w^ho  has 
bought  the  bill  may  have  done  so  with  the  understanding  that 
an  arrangement  would  be  made  to  surrender  the  shipping 
documents  before  payment  and  may  have  instructed  his  for- 
eign representative  to  that  effect.  Furthermore,  even  in  the 
absence  of  express  permission,  the  correspondent,  because  of 
his  faith  in  the  importer,  may  undertake  on  his  own  initiative 
to  depart  from  the  documentary  instructions  and  release  the 
bill  of  lading,  though  in  so  doing  he  will  be  taking  upon  his 
own  shoulders  the  obligation  to  indemnify  the  owner  of  the 
draft  for  loss  through  default  of  payment.  If  we  assume  for 
the  sake  of  simplicity  that  the  correspondent  is  instructed  to 
release  the  bill  of  lading  before  payment,  the  arrangement 
made  with  the  importer  may  take  one  of  the  following  forms : 

(a)  The  bills  of  lading  may  be  surrendered  against  no 
greater  security  than  the  importer's  written  receipt. 
It  is  apparent  that  such  liberal  treatment  will  be  ac- 
corded only  those  firms  of  the  highest  credit  standing 
whose  patronage  is  valued  by  the  banker.  The  re- 
ceipt adds  nothing  to  the  security  of  the  acceptance 
which  the  banker  already  holds,  being  nothing  more 
than  an  expression  of  intended  good  faith  on  the  part  of 
the  importer.  This  simple  arrangement,  though  not 
unknown,  is  relatively  rare  in  international  trade;  it  is 
not  considered  good  banking  practice,  since  it  mul- 
tiphes  the  banker's  risk  and  subjects  him  to  the  hazards 
of  the  client's  business.  To  give  strength  to  the  receipt, 
endorsement  by  other  reputable  parties  is  sometimes 
required. 

(b)  A  second  plan,  adaptable  to  certain  kinds  of  goods,  pro- 
vides that  they  be  stored  by  the  banker  until  the  im- 
porter has  had  time  to  make  his  sales,  when  they  w'ill 
be  released  either  in  installments  or  in  a  single  lot  for 


COMMERCIAL  BILLS  181 

delivery  to  the  importer's  customers.  The  proceeds  of 
the  sale  are  paid  over  directly  to  the  banker  and  applied 
by  him  to  the  redemption  of  the  importer's  acceptance ; 
the  latter,  however,  is  not  released  from  his  obligation 
as  drawee  and  must  make  good  any  discrepancy  be- 
tween the  receipts  from  the  sale  and  the  face  of  the 
acceptance.  By  this  arrangement,  the  importer  never 
really  acquires  legal  ownership  of  the  goods  at  all,  with 
the  exception  of  that  portion,  if  any,  which  remains 
after  the  funds  accumulating  in  the  banker's  hands 
have  equaled  the  face  of  the  draft.  The  method  is 
sometimes  employed  by  houses  importing  general  mer- 
chandise for  distribution  to  the  wholesale  trade.  It  is 
not  adaptable  to  the  needs  of  the  manufacturer  who 
imports  machinery  or  raw  materials  for  his  own  use, 
since  it  prevents  the  importer  from  becoming  legal 
owner  of  the  goods,  as  explained. 

Moreover,  from  the  banker's  viewpoint  there  are  cer- 
tain decided  objections  to  the  practice  of  making  par- 
tial deliveries  of  goods  before  the  drawee  has  performed 
his  obligations.  The  practical  difficulties  are  great. 
It  is  almost  impossible  for  the  banker  to  be  sure  that 
the  importer  is  withdrawing  no  more  than  the  per- 
mitted fraction  of  the  goods  for  which  he  makes  pay- 
ment; this  fraction  is  one  of  values  and  not  of  quanti- 
ties, and  the  banker  or  his  agent  may  be  deceived  as  to 
the  relative  values  of  the  different  packages  of  which 
the  shipment  consists.  It  is  not  difficult,  also,  for  the 
importer  to  create  fictitious  sales  for  the  purpose  of 
deceiving  the  banker.  When  the  same  importer  has 
several  payment  drafts  and  several  consignments  of 
goods  held  by  the  same  banker  at  the  same  time,  it  is 
possible  for  him,  by  these  devices,  to  withdraw  those 
goods  for  which  a  good  market  exists,  leaving  the  others 
as  a  form  of  security  whose  value  dwindles  in  spite  of  the 
banker's  caution.  English  bankers,  for  these  reasons, 
rarely  adopt  the  practice;  it  is,  however,  widespread 
in  certain  countries,  and  especially  in  the  Far  East. 


182  FOREIGN  EXCHANGE 

(c)  A  third  mclliod,  and  one  more  frequently  employed  in 
the  United  States  is  the  dehvery  of  the  shipphig  docu- 
ments in  exchange  for  a  iruM  receipt.  This  document 
is  carefully  drawn  to  define  the  rights  and  duties  of  the 
banker  and  importer  with  respect  to  the  goods.  Its 
essential  characteristic  consists  in  the  agreement  that 
the  goods  are  the  property  of  the  bank  delivered  to  the 
importer  in  trust  for  a  certain  specified  purpose,  the 
latter  being  bound  to  maintain  their  identity  distinct 
from  the  rest  of  his  assets  and  to  hold  them  subject  to 
seizure  by  the  banker.  The  dehvery  of  raw  materials 
under  control  of  the  trust  receipt  is  very  common  in  the 
United  States  where  it  probably  originated.  The  Eng- 
lish bankers  condemn  the  practice;  often,  as  buyers  of 
payment  bills,  they  refuse  to  sanction  the  delivery  of 
the  goods  against  a  trust  receipt,  in  which  case  the  local 
banker  handling  the  collection  in  a  market  where  the 
device  has  a  recognized  standing,  frequently  exceeds 
his  authority,  avails  himself  of  this  method  of  making 
deliveries,  and  thus  makes  himself  liable  to  his  corre- 
spondent for  the  drawee's  obligation.  Though  the 
trust  receipt  is  devised  to  control  the  conduct  of  the 
importer  after  he  has  received  the  goods,  opportunities 
for  fraud  are  always  present;  hence,  it  is  the  banker's 
faith  in  the  character  of  his  client  which  leads  him  to 
make  delivery  of  the  shipping  documents.  The  effi- 
cacy of  the  trust  receipt  also  varies  in  different  coun- 
tries because  of  the  varying  degrees  to  which  the 
laws  recognize  the  bank's  property  in  goods  after  they 
have  been  delivered  to  the  acceptor  of  a  bill;  this  recog- 
nition, in  the  United  States,  is  more  nearly  unqualified 
than  in  other  countries,  and  this  fact,  in  part,  accounts 
for  the  popularity  of  this  device  with  our  bankers. 
The  form  of  the  trust  receipt  is  adapted  to  the  character  of 
the  goods  and  the  purpose  of  the  importer  with  regard  to 
them.  One  type  is  employed  in  cases,  similar  to  that  dis- 
cussed in  the  preceding  section,  where  the  goods  are  to  be 
delivered  only  after  their  sale  by  the  importer  has  been  con- 


COMMERCIAL  BILLS  183 

Form  9.  Trust  Receipt 

Received  from  The  First  Commercial  Bank  op  New  York  the 
following  goods,  their  property,  specified  in  the  Bills  of  Lading  per 

S.S dated 

marked  and  numbered  as  follows : 

(Description  of  goods) 

In  trust  to  deliver  the  same  to ". 

who  have  purchased  the  same  for 

payable  in 

and  to  obtain  from  the  purchaser  the  proceeds  of  the  sale  of  the  same. 

In  consideration  of  the  delivery  of  said  goods  to  me/us  in  trust  as 
above  I/we  agree  to  deliver  them  immediately  to  the  said  purchasers 
and  to  collect  the  proceeds  of  sale,  and  immediately  deliver  such 
proceeds  to  The  First  Coimmercial  Bank  of  New  York  in  what- 
ever form  collected,  to  be  applied  by  them  against  the  acceptances  of 
The  First  Commercial  Bank  of  New  York  on  my/our  account, 

under  the  terms  of  Letter  of  Credit  No issued 

for  my/our  account,  and  to  the  payment  of  any  other  indebtedness 
of  mine/ours  to  The  First  Commercial  Bank  of  New  York.  It  is 
understood,  however,  that  if  such  proceeds  be  in  notes  or  bills  paya- 
ble, they  shall  not  be  so  applied  until  paid,  but  with  liberty  to  The 
First  Commercial  Bank  of  New  York  to  sell  or  discount,  and  so 
apply  net  proceeds. 

The  First  Commercial  Bank  of  New  York  may  at  any  time 
cancel  this  trust,  and  they  may  take  possession  of  said  goods  until  the 
same  have  been  delivered  to  said  purchasers  and  the  proceeds  of  sale 
received  from  them,  and  thereafter  of  such  proceeds,  wherever  the 
said  goods  and  proceeds  may  then  be  found,  and  in  the  event  of  any 
suspension  or  failure  or  assignment  for  the  benefit  of  creditors  on 
my /our  part  or  of  non-fulfillment  of  any  obligation  or  of  non-pay- 
ment at  maturity  of  any  acceptance  made  by  me/us  under  said 
credit,  or  any  other  credit  issued  by  The  First  Commercial  Bank 
OF  New  York  on  my/our  account,  or  of  any  indebtedness  on  my/our 
part  to  them,  all  obligations,  acceptances,  indebtedness,  and  liabili- 
ties whatsoever  sliall  thereupon  (with  or  without  notice)  mature  and 
become  due  and  payable. 

Dated,  New  York  City 

(Signed) 


184  FOREIGN  EXCHANGE 

Form  10.  Trust  Receipt 

Received  from  The  First  Commercial  Bank  of  New  York  the 
following  goods,  their  property,  specified  in  the  Bill  of  Lading  per 

S.S dated 

marked  and  numbered  as  follows : 

(Description  of  goods) 

and,  in  consideration  thereof  I/we  hereby  agree  to  hold  said  goods  in 
trust  for  them,  as  their  property,  wuth  liberty  to  sell  the  same  for 
their  account,  and  further  agree,  in  case  of  sale,  to  hand  the  proceeds 
to  them  to  apply  against  the  acceptances  of  The  First  Commercial 
Bank  of  New  York  on  my/our  account,  under  the  terms  of  the 

Letter  of  Credit  No issued  for  my /our  account 

and  for  the  payment  of  any  other  indebtedness  of  mine/ours  to  The 
First  Commercial  Bank  of  New  York. 

The  First  Commercial  Bank  of  New  York  may  at  any  time 
cancel  this  trust  and  take  possession  of  said  goods,  or  of  the  proceeds 
of  such  of  the  same  as  may  then  have  been  sold,  wherever  the  said 
goods  or  proceeds  may  then  be  found  and  in  the  event  of  any  suspen- 
sion, or  failure,  or  assignment  for  the  benefit  of  creditors,  on  my /our 
part,  or  the  non-fulfillment  of  any  obligations,  or  of  the  non-payment 
at  maturity  of  any  acceptances  made  by  me/us  under  said  credit,  or 
under  any  other  credit  issued  by  The  First  Commercial  Bank  of 
New  York  on  my /our  account  or  of  any  indebtedness  on  my /our 
part  to  them,  all  obligations,  acceptances,  indebtedness  and  liabilities 
whatsoever  shall  thereupon  (with  or  without  notice)  mature  and  be- 
come due  and  payable.  The  said  goods  while  in  my/our  hands  shall 
be  fully  insured  against  loss  by  fire. 

Dated,  New  York  City 

(Signed) 


COMMERCIAL  BILLS  186 


Form  11.  Tktjst  Receipt 

(Documents  fok  Warehousing) 

Received  from  The  Fikst  Commebcial  Bank  of  New  York  Bill 

of  Lading  per  S.S dated 

for  the  following  goods,  their  property,  marked  and  numbered  as 
follows : 

(Description  of  goods) 

imported  under  the  terms  of  Letter  of  Credit  No 

issued  by  them  for  my/our  account  the  said  Bill  of  Lading  to  be  used 
by  me/us  for  the  sole  purpose  of  entering  the  above  described  prop- 
erty and  the  United  States  Custom  House  at  the  Port  of 

and  of  storing  the  same  in  the  name,  and  as  the  property,  of  The 
First  Commercial  Bank  of  New  York,  and  subject  only  to  their 
order,  I/we  hereby  agreeing  to  so  store  said  property  and  to  hand  the 
storage  receipt  to  the  said  The  First  Commercial  Bank  of  New 
York,  when  obtained. 

I/we  also  agree  to  fully  insure  said  property  against  fire,  the  loss, 
if  any,  paj'able  to  said  The  First  Commercial  Bank  of  New  York, 
and  to  hand  to  them  the  policies  of  insurance  thereon. 

Dated,  New  York  City 

(Signed) 


186  FOREIGN  EXCHANGE 

sunimated.'  All  payments  in  connection  with  the  sale  are 
to  be  liantied  to  the  banker,  regardless  of  the  fact  that  the 
importer's  draft  may  not  be  payable.  In  other  cases,  deliver- 
ies are  made  to  the  importer  before  he  has  made  his  sale,  under 
agreement  that  the  proceeds  will  be  handed  immediately  to 
the  bank.  This  type  of  receipt  is  esi)ecially  adaptable  to 
the  uses  of  the  importers  of  raw  materials,  who  are  therel)y 
enabled  to  withdraw  these  materials  from  storage  as  they  are 
needed  for  manufacture,  and  to  fill  orders  on  specification.^ 
Still  another  form  of  receipt  is  used  in  cases  where  it  is  neces- 
sary for  the  importer  to  obtain  the  shipping  documents  for 
the  single  purpose  of  clearing  the  goods  through  the  Custom 
House.  The  importer  is  then  bound  to  store  the  goods  to 
the  bank's  order  and  to  place  the  warehouse  receipt  in  the 
banker's  hands.  This  last  method,  of  course,  does  not  grant 
the  importer  any  real  control  over  the  shipment.  * 

By  one  of  these  methods,  importations  may  be  financed  by 
documentary  payment  bills  without  actually  exacting  pay- 
ment from  the  importer  in  advance  of  delivery,  thus  materi- 
ally reducing  the  inconveniences  of  the  payment  bill  as  an 
instrument  of  international  commerce.  Failing  these  de- 
vices for  releasing  the  shipping  documents,  the  acceptor  may 
have  recourse  to  prepayment  of  his  acceptance.  The  prepay- 
ment of  a  debt  always  lies  in  the  power  of  the  debtor,  but  the 
remission  of  interest  on  the  unexpired  portion  of  the  debt 
cannot  be  claimed  as  a  legal  right  in  case  of  prepayment.  An 
acceptance,  though  it  bears  no  explicit  rate  of  interest,  is 
bought  by  the  bankers  at  a  discount,  interest  being  involved 
in  the  difference  between  the  purchase  price  and  the  face 
value.  This  interest  the  banker  can  gain  by  holding  the 
acceptance  through  its  term  of  life;  and  if  he  cares  to  insist 
upon  this  right,  the  acceptor  has  no  power  to  compel  him  to 
forego  any  part  of  this  gain  by  virtue  of  an  offer  to  redeem 
the  bill  in  advance.  But,  as  we  have  seen,  it  is  ordinarily  not 
the  intention  of  the  banker  to  hold  a  bill  of  exchange  as  an 
investment.  In  the  case  of  most  acceptance  drafts,  he  will 
instruct  his  correspondent  to  sell  the  instrument  in  the  open 
»  See  Form  9,  page  183.    «  See  Form  10,  page  184.    »  See  Form  11,  page  185. 


COMMERCIAL  BELLS  187 

market  as  soon  as  acceptance  is  obtained  upon  it.  In  the  case 
of  payment  drafts,  these  not  being  discountable  in  the  money 
market,  an  ofiPer  from  the  acceptor  to  prepay  his  debt  at  the 
time  of  acceptance  or  afterwards  will  usually  find  the  banker 
willing  to  agree  to  a  remission  of  interest,  since  the  funds  re- 
turned by  the  prepayment  may  be  used  with  profit  in  other 
ways.  Many  importers  have  for  years  prepaid  all  their 
acceptances  as  soon  as  the  goods  have  arrived,  assuming  their 
right  to  receive  a  rebate  of  interest  as  if  this  right  had  the 
sanction  of  law;  and  the  bankers  who  buy  long  bills  drawn 
upon  these  importers  do  so  in  full  knowledge  of  the  fact  that 
prepayment  will  take  place  before  the  maturity  of  the  accept- 
ance. 

The  amount  of  rebate  allowed  an  acceptor  who  prepays  is 
governed  by  the  practice  of  the  market  in  which  he  lives.  In 
England  alone  is  the  practice  of  prepayment  so  widespread 
and  of  such  long  standing  that  special  machinery  has  de- 
veloped in  the  money  market  to  deal  with  it.  There  a  spe- 
cial rate,  called  the  retirement  rate  of  interest,  by  means  of 
which  the  amount  of  rebate  to  be  allowed  upon  prepayment 
is  determined,  is  published  periodically.  In  the  London 
money  market,  this  retirement  rate  is  established  at  a  point 
from  1/4  to  3/4  per  cent  lower  than  the  rate  of  discount  for 
prime  commercial  long  bills;  it  is  the  latter,  and  higher,  rate 
which  determines  the  banker's  buying  price  for  a  bill,  hence 
prepayment  leaves  him  a  margin  of  profit.  The  student  can 
easily  verify  this  statement  by  a  little  exercise  with  pencil  and 
paper;  let  him  discount  a  given  sum  at  4  per  cent  and  again  at 
3  1/2  per  cent:  the  former  result  will  represent  a  banker's 
buying  price  and  the  latter  his  selling  price  in  case  of  prepay- 
ment. The  holder  of  an  acceptance  need  not,  therefore,  ob- 
ject to  prepayment  on  the  ground  that  it  will  rob  him  of  the 
profit  which  induced  him  to  buy  the  draft.  In  markets  other 
than  London,  the  retirement  rate  is  not  fixed  with  precision, 
being  determined  in  some  cases  by  the  parties  to  the  bill  of 
exchange  and  written  into  the  documentary  instructions;  in 
others,  governed  by  a  somewhat  variable  practice  among  the 
bankers  of  the  country.    With  few  exceptions,  however,  pre- 


188  FOREIGN  EXCIUNGE 

payment  with  rebate  of  interest  takes  place  in  all  the  ex- 
cluin<;o  markets  of  the  world. 

Wiien  it  is  the  importer's  intention  to  prepay  the  accept- 
ance, either  at  the  time  of  acceptance  or  a  few  days  later,  the 
documentary  p.ayment  bill  becomes  from  his  point  of  view 
much  like  a  demand  draft  or  conmiercial  bill  at  short  sight. 
Yet  there  are  reasons  why  the  payment  bill  serves  his  purpose 
better  than  either  of  the  other  two.  To  understand  these 
reasons,  we  must  first  recall  that  the  dominant  motive  im- 
pelling an  importer  to  prefer  a  long  bill  to  a  sight  draft  is  his 
desire  to  postpone  payment  until  after  he  has  opportunity  to 
dispose  of  the  goods.  A  sight  draft  wull  usually  arrive  in  ad- 
vance of  the  shipment,  if  both  are  sent  by  the  foreign  seller 
at  the  same  time,  and  so  is  likely  to  result  in  payment  in  ad- 
vance of  delivery.  A  bill  at  short  sight  —  that  is,  drawn  for 
less  than  thirty  days  —  may  have  a  similar  result.  Bills  of 
exchange  cannot  legally  bear  an  indeterminate  date  of  ma- 
turity, whereas  the  delays  of  ocean  traffic  make  the  arrival  of 
the  goods  at  the  port  of  destination  indeterminate.  Hence, 
a  bill  drawn  at  short  sight  against  a  freight  shipment  will 
mature  on  the  day  the  goods  arrive  only  by  a  stroke  of  luck. 

However,  even  if  sight  drafts  could  be  handled  in  such  a 
way  as  to  guard  against  payment  in  advance  of  delivery,  there 
remain  sufficient  reasons  why  the  importer  may  prefer  the 
payment  draft  with  the  option  of  prepayment.  This  choice 
between  prepaying  his  acceptance  or  allowing  it  to  run  to  ma- 
turity is  a  valuable  consideration  to  a  merchant  whose  trans- 
actions are  subject  to  the  fluctuations  of  the  market.  If  he 
should  have  difficulty  in  disposing  of  his  goods,  he  will  be  pro- 
tected against  a  hurried  liquidation  due  to  pressure  to  meet 
the  purchase  price.  On  the  other  hand,  if  he  turns  over  the 
merchandise  quickly,  a  way  is  open  to  reduce  the  cost  of  the 
transaction  by  prepaying  his  acceptance  at  a  discount.  In 
brief,  he  is  free  to  prepay  his  draft  and  obtain  his  goods,  or  to 
let  the  draft  mature  and  goods  lie  in  storage  according  to  the 
dictates  of  self-interest. 

A  variation  of  the  practice  of  prepayment  has  added  to  the 
value  of  this  option  to  the  import  merchant.    This  is  the  per- 


COMMERCIAL  BILLS  189 

mission  given  him  of  paying  in  advance  any  portion  of  his 
acceptance  that  he  wishes  to  pay,  allowing  the  balance  to  run 
to  a  later  date  or  to  maturity.  When  a  portion  of  the  ac- 
ceptance is  prepaid,  the  goods  are  released  from  the  store- 
house in  amount  proportionate  to  the  payment,  and  are, 
therefore,  available  in  allotments  large  or  small  as  need 
arises  for  them.  To  illustrate,  let  us  assume  that  a  miller 
in  England  has  imported  six  thousand  bushels  of  wheat  from 
America  and  has  accepted  a  ninety-day  payment  draft  for 
their  value,  the  wheat  to  be  warehoused  by  the  banker 
pending  payment  of  the  acceptance.  Assume,  further,  that 
the  miller  can  use  his  wheat  profitably  in  three  equal  amounts 
every  tliirty  days.  The  first  installment  can  be  withdrawn 
the  day  the  wheat  arrives,  say  ten  days  after  the  acceptance 
of  the  draft,  by  prepayment  of  one  third  of  the  amount  of  the 
bill  at  eighty-three  days'  discount  (in  England  three  days' 
grace  are  added  to  the  term  of  the  bill);  the  second  install- 
ment will  be  released  thirty  days  later  upon  payment  of  an- 
other third  of  the  bill  at  fifty-three  days'  discount;  and  the 
final  installment  after  another  thirty  days  upon  payment  of 
the  balance  of  the  bill  at  twenty-three  days'  discount.  Un- 
der this  arrangement,  the  miller  is  neither  compelled  to  pay 
for  his  goods  before  he  can  make  use  of  them,  as  would  have 
happened  if  the  transaction  had  been  financed  by  a  sight 
draft,  nor  to  wait  longer  than  he  wishes  in  order  to  get  them, 
as  he  would  have  been  compelled  to  do  in  the  absence  of  the 
option  of  prepayment. 

46.  Clean  bills.  A  small  number  of  commercial  long  bills 
are  clean;  that  is,  free  from  attached  documents.  Business 
houses  of  high  standing  which  have  had  dealings  for  many 
years  sometimes  develop  a  degree  of  confidence  in  each  other 
so  high  that  the  seller  requires  no  collateral  security  in  support 
of  the  buyer's  promise.  In  such  cases,  one  of  the  motives  — 
namely,  the  desire  of  the  exporter  for  control  over  the  goods 
until  payment  is  made  —  which  cause  the  drawing  of  docu- 
mentary bills  is  absent.  It  is  then  the  practice  of  the  ex- 
porter to  mail  the  bill  of  lading  and  other  documents  directly 
to  the  importer  some  days  before  drawing  against  the  ship- 


190  FOREIGN  EXCHANGE 

meiit.  After  sufficient  time  has  elapsed  to  allow  the  goods  to 
arrive,  a  bill  of  exchange  is  drawn  and  offered  for  sale  (or  col- 
lection) to  the  exporter's  banker.  Now,  just  as  the  exporter 
will  waive  collateral  security  only  in  favor  of  his  best  cus- 
tomers, so  the  banker  will  buy  the  resulting  bill  of  exchange 
only  from  exporters  of  the  highest  standing;  for  it  will  be  re- 
called that  the  banker  relies  upon  the  drawer's  contingent 
liability  for  security  against  dishonor  by  the  drawee.  This 
process  of  selection  exercised  by  exporter  and  banker  has  as 
a  necessary  consequence  the  fact  that  no  commercial  long 
bills,  free  from  documents,  are  to  be  found  in  the  exchange 
market  which  do  not  bear  names  of  the  highest  credit  rating 
both  as  drawer  and  as  drawee.  Students  of  foreign  exchange 
have  sometimes  been  puzzled  by  the  information  that  clean 
bills  often  command  better  rates  of  discount  from  the  bank- 
ers than  do  documentary  bills,  but  this  discrimination  in 
their  favor  results,  not  from  the  fact  that  they  are  clean,  but 
from  the  fact  that  the  parties  to  them  are  of  the  highest  stand- 
ing. To  state  it  otherwise,  the  premier  standing  of  some 
business  men  enables  them  at  the  same  time  to  draw  clean 
bills  and  to  sell  these  bills  at  unusually  favorable  rates;  but 
documentary  bills  bearing  the  same  names  would  command 
equally  favorable  rates. 

Clean  bills  are  preferred  by  business  men  to  other  forms  of 
drafts,  not  because  they  command  better  rates  (for,  as  has  just 
been  said,  merchants  who  are  able  to  sell  clean  bills  could  com- 
mand the  lowest  rates  for  any  of  their  drafts),  but  because  of 
the  superior  convenience  of  the  clean  bill.  By  receiving  his 
bill  of  lading  directly  from  the  exporter,  the  importing  mer- 
chant is  freed  from  whatever  inconvenience  is  involved  in 
negotiating  for  its  release  from  the  bankers  who  are  financing 
the  transaction.  Moreover,  his  receipt  of  the  bill  of  lading 
in  advance  of  the  arrival  of  the  goods  provides  security 
against  delay  and  a  possible  break  in  the  continuity  of  his 
business  operations  which  might  result  if  the  goods  were  to 
be  held  up  on  the  docks. 

47.  Commercial  bills  at  sight  and  short  sight.  It  is  esti- 
mated that  ninety  per  cent  of  the  international  trade  of  the 


COMMERCIAL  BILI5  191 

world  is  financed  by  commercial  long  bills,  the  majority  of 
which  are  drawn  at  sixty  or  ninety  days'  sight;  however,  the 
commercial  bill  payable  at  sight  or  a  small  number  of  days 
after  sight  is  not  unknown.  We  repeat  that  the  bill  of  ex- 
change arising  from  a  particular  transaction  is  but  one  of  a 
number  of  details  covered  by  the  terms  of  sale,  and,  like  the 
details  of  price,  quality,  and  quantity  of  the  goods,  is  open 
to  many  possible  adjustments  at  the  time  the  bargain  is 
struck.  Thus  both  parties  sometimes  agree  that  the  buyer 
shall  pay  for  the  goods  cash  on  delivery,  and  that,  to  give 
effect  to  this  agreement,  the  seller  shall  draw  a  sight  or  short 
sight  draft  against  the  buyer  or  his  banker.  Or,  the  goods 
may  be  sold  on  open  book  account  with  the  agreement  that, 
when  payment  is  due,  the  seller  collect  by  drawing  a  sight 
draft  against  the  buyer  or  his  banker  to  arrive  approxi- 
mately on  the  day  of  payment. 

Strictly  interpreted,  the  sight  draft  imposes  on  the  banker 
the  duty  of  making  presentment  immediately  upon  its  ar- 
rival, which,  because  of  the  discrepancy  between  mail  and 
freight  time,  may  lead  to  payment  in  advance  of  the  delivery 
of  the  goods.  To  avoid  this  result,  customs  have  arisen  in 
some  markets  which  modify  the  strict  meaning  of  the  sight 
draft,  causing  the  bankers  to  postpone  presentment  for  some 
days,  or  until  the  arrival  and  inspection  of  the  goods.  When 
so  treated,  the  sight  draft  becomes  virtually  a  bill  drawn  for 
a  short  period  after  date  and  will  be  so  considered  when 
bought  by  bankers  familiar  with  the  customs  of  the  importing 
market.  The  draft  drawn  for  three,  five,  or  seven  days  after 
sight  is  likewise,  in  most  cases,  the  result  of  cash  on  delivery 
sales,  the  date  of  payment  being  calculated  to  compensate  the 
difference  between  mail  and  freight  time.  These  are  usually 
documentary  payment  bills  drawn  against  perishable  goods. 
They  are,  however,  adaptable  to  any  transaction  in  which  the 
buyer  intends  cash  payment;  hence,  with  the  development  of 
faster  freight  steamers  they  are  coming  into  vogue  as  a  substi- 
tute for  long  payment  bills  in  the  case  of  many  buyers  who 
have  customarily  prepaid  their  acceptances.  This  is  said  to 
^*»  true  of  our  sal*''*  of  cotton  to  the  largest  English  importers. 


192  FOREIGN  EXCHANGE 

Short  coninicrcial  bills,  however,  remain  the  exception  to  the 
rulr  in  foroijiu  trade. 

48.  Modification  of  the  commercial  bill.  We  may  now 
take  account  of  variations  in  the  form  and  treatment  of  com- 
mercial hills  which  appear  in  our  relations  with  certain  mar- 
kets of  the  world.  Thus  far  it  has  been  assumed  that  the  ex- 
porter will  draw  the  bill  in  the  money  of  the  importer  and  that 
the  latter  will  discharge  his  obligation  by  making  payment  to 
a  local  banker  of  the  face  of  the  bill  in  this  local  money.  The 
result,  when  the  bill  of  exchange  is  drawn  in  this  form,  is  that 
both  exporter  and  importer  deal  in  the  money  of  their  re- 
spective countries,  and,  also,  that  the  importer  is  called  upon 
to  pay  only  the  fixed  amount  stated  on  the  face  of  the  bill. 
This  is  the  usual,  though  not  the  universal,  practice.  The 
principal  exceptions  which  we  shall  consider  either  require 
payment  by  the  importer  in  some  form  of  foreign  exchange, 
or  else  leave  the  amount  to  be  paid  open  to  the  influence  of 
fluctuations  in  the  rates  of  exchange.  These  exceptions  are 
especially  important  with  regard  to  two  groups  of  markets: 
(a)  South  Africa  and  Australia;  (b)  South  America. 

The  Australasian  colonies  of  the  British  Empire  have  the 
same  monetary  system  as  England  and  are  closely  related  to 
London  through  their  banking  structure.  Importers  in  these 
markets,  dealing  through  local  branches  of  London  banks, 
frequently  establish  credits  in  London  against  which  they  in- 
struct the  exporters  to  draw  for  the  value  of  the  goods  shipped. 
The  credit  in  London  may  be  created  by  paying  into  the  local 
colonial  bank  in  local  money  the  equivalent  of  this  credit  at 
the  bank's  current  rate  of  exchange,  a  process  tantamount  to 
buying  a  bill  of  exchange  payable  in  London,  the  proceeds  to 
be  held  in  that  city  subject  to  the  draft  of  the  foreign  exporter. 
Various  differences  in  practice  arise  with  regard  to  this  pay- 
ment by  the  importer.  It  may  not  be  made  until  the  draft 
drawn  by  the  exporter  and  accepted  in  London  is  approaching 
maturity,  though  to  postpone  payment  in  this  manner,  the 
importer  must  come  to  some  agreement  with  the  London 
bank  through  its  local  branch,  whereby  acceptance  of  the 
exporter's  draft  can  be  secured  in  consideration  of  the  im- 


COMMERCIAL  BHXS  19S 

porter's  promise  to  remit  the  funds  required  to  redeem  the 
draft  before  maturity.  This  process  is  very  similar  to  that 
which  is  followed  when  a  commercial  letter  of  credit  is  em- 
ployed; it  will  be  discussed  at  length  in  the  following  chapter 
and  we  shall,  therefore,  pass  it  over  in  this  place  without 
further  explanation.  In  any  case,  the  amount  paid  by  the 
Australasian  importer  will  be  governed  by  the  bank's  rate  of 
exchange  for  London  bills,  on  the  assumption  that  the  pay- 
ment will  be  converted  into  a  sterling  bill  which  will  be  sent 
to  London  as  an  offset  for  the  exporter's  draft.  But  in  prac- 
tice, especially  if  the  importer  deals  with  a  local  branch  of  a 
London  bank,  the  payment  may  be  carried  upon  the  accounts 
of  the  two  banks  for  an  extended  period  without  remittance 
by  the  colonial  branch  to  the  London  office.  Regardless  of 
these  details,  however,  this  method  of  paying  through  London 
for  imports  from  other  markets  is  equivalent  to  covering  the 
exporter's  bills  with  exchange  drawn  on  a  third  country. 
From  the  point  of  view  of  the  exporters,  the  practice  has  the 
merit  of  making  it  possible  to  draw  London  bills  against  goods 
sold  in  Australasia,  and,  thus,  to  take  advantage  of  the  rela- 
tively stable  rate  on  sterling  exchange. 

When  this  process  of  collecting  through  London  is  not 
adopted,  the  commercial  bill  of  exchange  arising  from  sales 
of  our  goods  in  Australasian  markets  will  be  drawn  directly 
upon  the  importer.  Then  it  will  usually  bear  what  is  known 
as  the  Colonial  Clause.  The  amount  due  is  stated  in  the  im- 
porter's money  (which  is  the  same  as  English  money)  and  the 
bill  of  exchange  bears  the  following  additional  words:  "Pay- 
able with  exchange  (British  and  Colonial  Stamps  added)  at 
the  current  rate  in  London  for  negotiating  bills  on  the  Colo- 
nies. "  The  inclusion  of  this  clause  has  two  important  effects; 
in  the  first  place,  it  makes  the  amount  payable  by  the  im- 
porter a  variable  amount,  governed  by  the  rate  quoted  in 
London  on  bills  of  like  tenor  drawn  on  Australasian  markets; 
in  the  second  place,  because  of  the  variable  nature  of  the  im- 
porter's payment,  the  bill  is  worth  its  face  value  in  London 
at  the  time  of  drawing,  regardless  of  its  length  of  life.  The 
second  effect  of  the  Colonial  Clause  is  important  from  the 


194  FOREIGN  EXCHANGE 

standpoint  of  the  drawer,  since  it  gives  him  a  London  credit 
of  a  fixotl  amount  which  he  can  sell  at  the  sterling  sight  rate  of 
exchange.  To  make  clear  these  two  features  of  the  bill  bear- 
ing the  Colonial  Clause,  some  explanation  is  necessary. 

To  repeat,  the  Colonial  Clause  requires  the  importer  to  pay 
the  face  amount  of  the  bill  '^wiih  exchange  at  the  current  rate 
in  London  "  for  bills  of  this  character,  and,  in  addition,  to  pay 
all  stamp  charges.  The  phrase  "with  exchange"  is  not  used 
in  its  ordinary  sense  —  denoting  bills  of  exchange  —  but 
should  be  expanded  to  read,  "with  exchange  charges."  A 
bill  drawn  on  Melbourne  which  calls  for  the  payment  of  one 
thousand  pounds  "with  exchange"  exacts  from  the  drawee 
at  maturity  the  payment  of  the  face  of  the  bill  (£1000)  plus 
whatever  premium  is  necessary  to  make  the  bill  worth  this 
face  amount  at  the  time  of  drawing  —  that  is,  to  free  the  bill 
from  the  necessity  of  discount  in  order  to  find  its  face  value. 
The  amount  of  this  premium,  it  is  obvious,  will  be  determined 
by  the  London  quotation  on  similar  bills  drawn  on  Melbourne, 
for  the  quotation  is  calculated  in  such  a  way  as  to  express  the 
difference  between  the  face  value  of  a  time  draft  on  Mel- 
bourne and  the  present  value  of  such  a  draft. 

To  illustrate,  assume  that  the  bill  in  question  is  drawn  at 
thirty  days'  sight  and  that  the  London  quotation  on  such 
bills  is  98.  This  quotation  means  that  ninety-eight  pounds 
will  be  given  in  London  for  each  one  hundred  pounds  payable 
in  Melbourne  thirty  days  later  —  a  discount  of  two  per  cent. 
The  Colonial  Clause  compels  the  drawee  to  pay  this  two  per 
cent  in  addition  to  the  face  of  the  bill,  and  also  any  stamp 
charges  which  may  be  applied  to  the  bill  in  London  and  Mel- 
bourne. If  this  bill,  bearing  the  Colonial  Clause,  is  offered 
for  sale  in  London,  the  bankers  need  not  discount  it  to  find  its 
present  value,  because  the  drawee  when  he  redeems  it  will  pay 
enough  in  addition  to  the  face  to  make  it  worth  one  thousand 
pounds  when  drawn.  In  strict  theory,  the  rate  which  deter- 
mines this  premium  payment  of  the  drawee  should  be  the  rate 
current  at  the  time  the  bill  is  drawn,  and  not  the  rate  current 
when  the  bill  is  paid;  for  the  purpose  of  the  premium  pay- 
ment is  to  make  the  bill  worth  its  face  when  drawn.    In  actual 


COMMERCIAL  BILLS  195 

practice,  however,  it  is  the  rate  current  when  the  bill  is  paid 
which  determines  how  much  "exchange"  the  drawee  must 
bear;  but  in  the  long  run  any  differences  between  these  two 
rates  are  equalized,  and  the  London  bankers  negotiate  these 
bills  on  the  assumption  that  they  are  worth  their  face  when 
drawn. 

Consider,  now,  the  effect  of  the  Colonial  Clause  upon  the 
receipts  of  the  American  exporter  who  offers  it  for  sale  to  his 
banker.  We  have  just  seen  that  a  bill  bearing  this  clause  will 
be  accepted  in  London  at  its  face  value;  to  the  New  York 
banker,  therefore,  it  is  equivalent  to  a  sterling  sight  draft. 
It  will  increase  the  banker's  London  credit  by  its  full  face 
amount  upon  arrival;  if  it  is  bought  by  the  New  York  banker, 
he  can  sell  at  once  his  own  sterling  sight  draft  for  the  same 
amount,  knowing  that  the  exporter's  bill  will  arrive  in  London 
with  the  same  mail  as  his  own  sterling  demand  draft,  and  that 
the  two  will  offset  each  other.  Hence,  the  exporter  will  ex- 
pect to  sell  his  commercial  long  bill  bearing  the  Colonial 
Clause  at  the  sterling  sight  rate  of  exchange;  this  is  higher 
than  the  sterling  long  rate  by  the  amount  of  the  discount 
which  the  long  bill  usually  suffers  when  sold  after  acceptance.  ^ 
It  comes,  then,  to  this:  the  exporter  is  enabled  by  the  Colonial 
Clause  to  sell  his  goods  on  time  without  suffering  loss  of  in- 
terest; the  importer  bears  this  loss  by  agreeing  to  pay  "ex- 
change "  at  the  time  his  draft  matures.  Another  effect  of  the 
Colonial  Clause,  important  from  the  standpoint  of  the 
exporter,  is  the  fact  that  it  enables  him  to  sell  bills  payable  in 
Australasia  at  the  relatively  stable  sterling  sight  rate  of 
exchange.  This  reduces  his  risk  of  loss  through  exchange 
fluctuations. 

Desire  to  avoid  risk  of  exchange  accounts,  also,  for  the  cus- 
tomary practice  of  making  bills  drawn  on  South  American 
markets  payable  by  the  importer  with  foreign  bills  of  ex- 
change. The  monetary  systems  of  these  countries  have  never 
been  very  stable;  few  of  them  have  to-day  an  unqualified  gold 
standard;  irredeemable  and  depreciated  paper  money  has 

*  See  pages  93  f.,  where  the  relation  of  the  long  rate  to  the  sight  rate  is  ex- 
plained. 


196  FOREIGN  EXCHANGE 

been  the  medium  of  exchange  over  most  of  the  continent 
throughout  its  history  as  a  group  of  independent  repubhcs. 
Rates  of  exchange  for  bills  drawn  in  these  money  units  have, 
in  the  past,  been  subject  to  wide  and  sudden  fluctuations, 
so  violent  as  to  preclude  the  use  of  such  bills  by  exporters  who 
wish  to  avoid  speculative  risks  in  their  foreign  business.  In 
their  efforts  to  utilize  the  bill  of  exchange  (chiefly  as  a  col- 
lection instrument)  in  their  trade  with  South  America  without 
at  the  same  time  running  serious  risk  of  loss,  American  ex- 
porters have  adopted  either  of  two  expedients:  (a)  drawing 
their  bills  to  require  payment  at  maturity  in  a  specified 
amount  of  dollar  exchange;  (b)  drawing  to  require  payment 
in  sterling  exchange.  This  is  known  as  payment  by  return 
draft;  payment  is  not  consummated  until  the  arrival  of  the 
funds  in  the  exporter's  market. 

The  commercial  bill  so  drawn  as  to  require  payment  by 
return  dollar  draft  bears  on  its  face  an  amount  stated  in  dol- 
lars and  cents  and  includes  these  words:  "Payable  in  legal 
currency  at  the  bank's  drawing  rate  on  the  day  of  payment 
for  sight  drafts  on  New  York."  To  redeem  such  a  draft,  the 
importer  must  either  deposit  the  designated  amount  in  the 
form  of  dollar  sight  drafts,  or  pay  to  the  banker  who  holds  his 
acceptance  enough  local  currency  to  purchase  these  sight 
drafts  at  the  current  rate  on  New  York.  The  sight  drafts 
with  which  payment  is  made  in  South  America  will  be  the 
property  of  the  exporter  who  drew  the  bill  of  exchange,  or  of 
his  banker,  if  the  latter  has  bought  the  exporter's  bill.  They 
must  be  forwarded  to  New  York  and  there  presented  for  en- 
cashment before  the  transaction  is  finally  cleared  up.  Since 
most  of  these  bills  are  taken  for  collection,  the  exporter  must 
wait  during  the  entire  period  required  to  mail  the  bill  to 
South  America  for  acceptance  plus  the  term  of  life  of  the  bill, 
plus  the  mail  time  of  the  return  draft.  But  he  is  freed  from 
all  risk  of  loss  by  reason  of  any  fluctuation  in  the  rates  of  ex- 
change, since  his  bill,  payable  in  dollars,  is  not  converted  at 
any  stage  of  its  history  into  a  foreign  currency.  If  he  suc- 
ceeds in  selling  his  bill  to  a  banker,  the  buying  price  will  be  its 
face  value  minus  interest  during  the  period  which  must 


COMMERCIAL  BILLS  197 

elapse  before  the  arrival  of  the  return  draft,  minus  bankers' 
commissions.  Hence,  the  use  of  this  type  of  commercial  bill, 
whether  sold  to  the  banker  or  left  for  collection,  involves  for 
the  exporter  a  relatively  heavy  interest  charge,  but  no  risk  of 
exchange.  Being  forewarned  of  this  loss  of  interest  at  the 
time  of  stating  his  terms  of  sale,  the  exporter  can  include  it, 
together  with  bankers'  commissions,  in  the  sale  price  of  his 
goods  and  thus  pass  it  on  to  the  importer.  From  the  latter's 
point  of  view,  the  bill  requiring  a  return  draft  in  dollars  is 
obviously  less  desirable  than  one  drawn  in  his  own  money, 
since  it  throws  his  business  transaction  open  to  risks  of  ex- 
change whose  magnitude  he  cannot  foresee.  This  makes  it 
impossible  for  him  to  foretell  with  precision  what  his  importa- 
tion is  to  cost,  and  acts  as  a  handicap  to  the  conduct  of  his 
business.  ^ 

Somewhat  more  complex  is  the  second  type  of  bill  em- 
ployed in  our  South  American  trade  —  that  is,  the  bill  pay- 
able in  a  designated  amount  of  sterling  exchange.  The  ex- 
porter employing  this  type  of  bill  must  price  his  goods  in 
sterling,  draw  upon  the  importer  for  the  proper  amount  in 
that  money,  and  write  on  the  face  of  his  bill,  "Payable  in 
legal  currency  at  the  bank's  drawing  rate  for  ninety  days' 
sight  drafts  on  London."  In  some  cases,  though  rarely,  this 
clause  will  designate  sterling  sight  drafts  instead  of  sterling 
bills  at  ninety  days'  sight;  this  matter  of  the  usance  of  the 
return  draft  is  of  some  importance  to  the  importer  as  we  shall 
see  in  a  moment.  In  either  case,  upon  maturity  of  the  ex- 
porter's bill,  the  importer  must  make  payment  by  depositing 
with  the  banker  who  holds  his  acceptance  sufficient  local  cur- 
rency to  purchase  the  return  draft  at  the  current  sterling  rate 
of  exchange,  or  else  deposit  the  designated  sterling  bill  itself. 
As  in  the  case  of  a  return  draft  in  dollars,  payment  is  not 
effected  until  the  funds  arrive  in  New  York  where  they  are 
the  property  of  the  exporter  or  his  banker,  if  the  latter  bought 
the  bill  on  the  South  American  importer. 

Merchants  in  South  America  have  preferred  that  the  return 
draft  be  a  long  bill  rather  than  a  sight  bill  because  the  former 
^  He  can,  of  course,  guard  against  this  risk  by  "Lcdgiug." 


198  FOREIGN  EXCHANGE 

opened  up  to  them  the  possibiUty,  with  the  aid  of  their  bank- 
ers, of  postponing  actual  payment  for  their  goods  and  thus 
resolving  the  importation  into  a  long  term  credit  transaction. 
In  exjilanation  of  this  matter,  let  us  assume  a  typical  case. 
An  American  exporter  has  shipped  goods  to  Rio  and  drawn  a 
bill  requiring  a  return  draft  of  one  thousand  pounds  sterling 
thirty  days  after  acceptance.     If  this  return  draft  is  to  be  a 
sight  bill,  the  Brazilian  importer  must  make  actual  payment 
for  his  goods  at  the  maturity  of  his  acceptance;  his  banker 
can  supply  him  with  a  sterling  sight  bill  only  by  drawing  upon 
his  London  balance,  and  this  he  will  not  do  unless  he  can 
cover  his  draft  at  once.     This  cover  he  \\all  buy  with  the 
money  received  from  the  importer  for  whose  benefit  the  return 
draft  is  drawn ;  thus  the  importer  will  be  called  upon  to  make 
payment  at  the  maturity  of  his  acceptance.    If,  now,  allowing 
for  difference  in  mail  and  freight  time  from  New  York,  we 
suppose  that  the  importer's  goods  arrived  fifteen  days  later 
than  the  bill  of  exchange  which  the  exporter  drew  upon  him, 
we  find  that  he  has  gained  possession  of  his  goods  only  fifteen 
days  before  his  acceptance  matures.     (The  bill  of  exchange, 
it  must  be  recalled,  w^as  drawn  for  thirty  days'  sight.)     These 
fifteen  days,  accordingly,  represent  the  maximum  period  al- 
lowed the  importer  to  turn  over  the  goods  before  paying  for 
them,  under  the  assumption  that  he  redeems  his  acceptance 
with  a  return  sight  draft.     But  suppose  that  the  return  draft 
is  a  ninety  days'  sterling  bill.     It  is  possible  for  the  importer 
to  obtain  such  a  bill  from  his  banker  without  making  immedi- 
ate payment  for  it,  though  to  do  so  he  must  have  sufficient 
credit  with  his  banker,  and  must  pay  commissions.      The 
banker  can  draw  a  bill  at  ninety  days'  sight  upon  his  London 
correspondent  who  will  accept  it  upon  presentation  and  under- 
take to  pay  it  out  of  funds  received  from  the  drawer  ninety 
days  later.    Since  immediate  cover  is  not  needed  for  the  re- 
turn draft,  the  importer's  banker  may  give  him  the  benefit  of 
this  extra  period  by  requiring  payment,  not  when  the  return 
draft  is  drawn,  but  ninety  days  later  when  it  is  time  to  remit 
cover  to  London.     This  makes  possible  a  lengthening  of  the 
time  allowed  the  importer  to  dispose  of  his  goods  before  he 
need  make  actual  payment  for  them. 


COMMERCIAL  BILLS  199 

This  extra  credit  period  is  not  without  cost  to  the  importer 
in  South  America,  but  we  can  best  explain  this  question  of 
cost  by  examining  the  method  employed  by  the  American 
exporter  to  govern  his  drawing  when  a  sterling  return  draft 
is  specified.  Returning  for  a  moment  to  the  procedure  in  the 
case  of  a  dollar  return  draft,  we  recall  that  the  exporter  com- 
puted the  amount  for  which  he  drew  upon  the  South  Ameri- 
can buyer  by  adding  to  the  sale  price  of  his  goods  interest  for 
the  time  which  must  elapse  between  the  mailing  of  his  bill 
from  New  York  and  the  arrival  of  the  return  draft,  plus 
bankers'  commissions.  The  same  procedure  will  form  the 
base  of  his  calculations  when  the  return  draft  is  to  be  sterling. 
But,  in  this  case,  the  return  draft  must  be  turned  into  dollars 
at  the  appropriate  sterling  rate  of  exchange  before  the  ex- 
porter has  received  payment  for  his  goods.  As  we  know,  the 
rate  of  exchange  for  a  sterling  sight  draft  is  higher  than  the  rate 
for  a  sterling  long  bill;  hence,  the  amount  for  which  the  ex- 
porter draws  upon  his  South  American  customer  will  be 
smaller,  if  the  return  draft  is  drawn  at  sight.  Perhaps  a 
simple  example  will  help  to  make  this  clear.  Let  us  assume 
the  following  data:  (1)  the  exporter's  goods  are  valued  at 
$1000  in  New  York;  (2)  the  time  which  elapses  between  the 
shipment  of  the  goods  and  the  arrival  of  the  return  draft  is 
ninety  days  (mail  time  both  ways  plus  the  life  of  the  ex- 
porter's thirty-day  sight  draft  on  the  importer) ;  (3)  bankers* 
commissions  are  $10.  This  gives  us  the  following  compu- 
tation : 

Value  of  goods  m  New  York $1000 

Interest  (1000  X  .06  X  90/360) 15 

Commissions 10 

$1025 

If  the  return  draft  is  to  be  drawn  in  dollars,  the  exporter  will 
draw  upon  his  foreign  customer  for  $1025  and  include  in  his 
bill  the  words,  "Payable  in  legal  currency  at  the  bank's  draw- 
ing rate  for  sight  drafts  on  New  York."  He  can  discount 
his  bill  for  $1000  with  a  New  York  banker  and  thus  receive 
the  correct  price  for  his  goods;  or  he  can  leave  the  bill  for 


200  FOREIGN  EXCHANGE 

collection  and  receive  a  payment  ninety  days  later  of  $1025, 
thus  <;aining  interest  for  himself. 

If  the  return  draft  is  to  be  in  slcrUng,  the  exporter  must 
draw  his  bill  in  sterling,  and  this  will  necessitate  his  turning 
the  $1025  which  he  requires  for  his  goods  into  pounds.  In- 
quiry at  his  bank  will  inform  him  that  a  return  sight  draft 
will  command  a  rate,  let  us  say,  of  4.85;  while  a  return  draft 
of  ninety  days'  sight  will  command  a  rate  of  4.80.  The  dif- 
ference between  these  two  rates  is  determined  chiefly  by  the 
discount  which  the  sterling  long  bill  suffers  when  sold  in  the 
London  market.  ^  Turning  $1025  into  pounds  sterling  at  the 
rate  of  4.85  gives  the  result,  £211  6s.  7  l/2d.  (1025  -^  4.85).  The 
same  sum  turned  into  pounds  sterling  at  the  rate  of  4.80 
gives  the  result,  £213  10s.  7  l/2d.  (1025  ^  4.80).  Thus,  if 
the  terms  of  sale  specify  that  the  exporter  shall  draw  requiring 
a  return  draft  in  sterling  sight,  he  will  draw  for  £211  6s.  7  l/2d. 
and  the  importer  must  redeem  the  bill  by  remitting  a  sterling 
sight  draft  of  this  amount;  if,  however,  the  terms  specify  a 
return  sterling  draft  of  ninety  days'  sight,  the  exporter  wall 
draw  for  £213  10s.  7  l/2d.,  and  the  importer  must  remit  a 
sterling  long  bill  of  this  amount.  It  will  be  seen  at  once  that 
the  exporter  is  not  concerned  about  the  usance  of  the  return 
draft,  since  he  is  at  liberty  to  adjust  the  face  of  his  bill  so  as  to 
obtain  a  predetermined  number  of  dollars.  In  either  case, 
if  he  sells  the  bill  to  his  banker,  he  will  receive  $1000  for  it; 
and,  if  he  deposits  it  for  collection,  he  will  receive  ninety  days 
later  a  sterling  bill  which  will  sell  for  $1025. 

Consider,  now,  the  effect  of  the  usance  of  the  sterling  re- 
turn draft  upon  the  South  American  importer.  If  the  return 
draft  is  at  sight,  he  must  buy  £211  6s.  7  l/2d.  at  the  maturity 
of  his  acceptance  at  the  rate  of  exchange  then  current  in  his 
market;  if  the  return  draft  is  a  ninety-day  bill,  he  may  obtain 
one  drawn  for  £213  10s.  7  l/2d.  at  the  maturity  of  his  accept- 
ance by  binding  himself  to  supply  this  amount  of  cover  in 
sterling  sight  drafts  ninety  days  later,  at  the  rate  then  current. 
This  ninety  days  of  credit,  therefore,  will  have  cost  him  what- 

^  See  pages  88  f .,  where  the  relation  of  the  sterling  sight  rate  to  sterling 
long  rate  is  explained. 


COMMERCIAL  BILLS  201 

ever  he  is  required  to  pay  for  the  extra  two  pounds  and  four 
shillings,  plus  the  commission  demanded  by  his  banker  for 
the  service  of  supplying  the  sterling  long  bill  in  advance  of 
cover.  Will  it  be  worth  his  while  to  obtain  at  this  cost  an  ex- 
tension of  the  time  within  which  he  is  required  to  pay  for  his 
goods?  The  answer  depends  upon  whether  the  interest  rates 
in  Rio  are  higher  than  in  London,  or  vice  versa.  It  must  be 
repeated  that  the  amount  by  which  the  sterling  long  bill  ex- 
ceeds the  sterling  sight  bill  is  determined  by  the  interest  rate 
in  the  London  market  where  the  long  bill  is  discounted  after 
acceptance;  it  is,  therefore,  at  this  rate  that  the  importer  ob- 
tains his  ninety  days'  credit  when  he  employs  a  long  return 
draft  for  this  purpose.  His  other  alternative  is  to  borrow  for 
ninety  days  in  his  own  market,  redeem  his  acceptance  in 
sterling  sight  exchange,  and  repay  his  loan  ninety  days  later; 
in  this  way  he  can  postpone  actual  payment  for  his  goods  for 
the  same  length  of  time.  In  the  past,  however,  the  interest 
rates  in  all  South  American  markets  have  been  very  much 
higher  than  in  London.  It  has  been  cheaper  for  South  Amer- 
ican importers  to  obtain  credit  by  employing  long  sterling 
return  drafts,  even  at  the  added  cost  of  bankers'  commis- 
sions, than  to  borrow  from  their  own  bankers.  Accordingly, 
they  have  employed  sterling  sight  return  drafts  only  to  a 
limited  extent. 

From  the  point  of  view  of  American  exporters,  the  use  of 
commercial  bills  bearing  the  return  draft  requirement  renders 
a  double  service;  in  the  first  place,  it  throws  the  interest  cost 
and  the  cost  of  banking  service  upon  the  buyer  in  the  foreign 
market;  secondly,  it  frees  the  exporter  from  risk  of  loss  due  to 
adverse  fluctuations  in  the  rates  of  exchange.  When  the 
return  draft  is  not  in  dollars,  but  in  some  foreign  money,  the 
exporter,  to  be  sure,  must  resolve  the  return  draft  into  dollars 
at  a  rate  of  exchange,  and,  thus,  apparently  runs  some  risk  of 
loss.  But  he  discovers  what  this  rate  will  be  before  drawing 
upon  the  importer  and  adjusts  the  face  of  his  bill  so  as  to 
avoid  the  risk.  The  importer,  on  the  other  hand,  cannot 
escape  risk  of  loss  from  exchange  fluctuations,  since  he  ob- 
ligates himself  to  buy  exchange  at  a  future  date  and  at  a  rate 


202  FOREIGN  EXCILVNGE 

which  cannot  be  foreknown;  hence,  he  does  not  know  with 
certainty  what  his  goods  have  cost  until  after  they  have 
arrived  and,  perhaps,  have  been  sold.  Obviously,  the  more 
violent  the  customary  fluctuation  of  the  rates  of  exchange 
ai)i)lying  to  the  type  of  bill  which  is  specified  for  the  return 
draft,  the  larger  the  element  of  risk  in  the  transaction  from 
the  standpoint  of  the  importer.  In  this  regard,  sterling  has 
been  much  preferred  in  times  past;  because  of  a  broader  de- 
mand and  supply  for  sterling  in  the  exchange  markets  of 
South  America,  fluctuations  in  the  sterling  rates  have  been 
confined  within  limits  relatively  narrow  as  compared  with  the 
dollar  rates.  The  changes  which  have  taken  place  since  the 
outljreak  of  the  Great  War  have,  however,  partially  removed 
the  impediment  in  the  way  of  employing  dollar  return  drafts 
in  South  America,  and,  as  a  consequence  of  the  greater 
stabilization  of  the  dollar  rates,  remittances  of  dollar  ex- 
change have  become  much  more  common  in  our  trade  with 
that  continent.^ 

Before  dismissing  this  subject,  one  other  modification  of 
the  commercial  bill  should  be  considered.  In  the  trans- 
action just  discussed,  the  exporter  passed  the  interest  charges 
on  to  the  importer  by  adding  them  to  the  sale  price  of  his 
goods  and  drawing  for  the  full  amount.  But  the  same  object 
is  obtained,  in  the  case  of  some  collection  drafts,  by  adding 
an  explicit  rate  of  interest  to  the  face  of  the  draft  itself  and 
requiring  the  importer  to  pay  the  increased  amount  when  the 
draft  falls  due.  Thus  the  exporter's  bill  will  read,  "Payable 
in  legal  currency  at  the  bank's  drawing  rate  on  the  day  of 
payment  for  sight  drafts  on  New  York,  with  interest  at  six 
per  cent  per  annum  from  the  date  of  drawing  to  the  approxi- 
mate date  of  arrival  of  return  funds  in  New  York."  This 
interest  clause  appears  almost  solely  in  collection  drafts, 
since  the  bankers  insist  on  the  inclusion  of  the  interest  in  the 
face  of  the  draft  itself  when  they  agree  to  buy  the  exporter's 
paper.  Commercial  bills  bearing  the  interest  clause  are  com- 
mon in  collections  of  payments  due  from  most  of  our  foreign 
markets  outside  of  Europe,  with  the  exception  of  certain 
^  See  the  discussion  in  Chapter  XIV. 


COMMERCIAL  BILLS  203 

South  American  countries  where  they  are  prohibited  by  law. 
Foreign  buyers  obtain  credit,  by  this  method,  at  the  rate 
current  in  the  United  States,  in  preference  to  borrowing  from 
their  own  bankers  and  paying  cash  for  their  importations, 
because  of  the  relatively  low  rates  of  interest  in  our  country 
compared  with  those  of  most  non-European  markets. 

NOTE  TO  CHAPTER  VII 

The  abnormal  credit  conditions  which  have  followed  the  war  have 
led  to  a  much  more  frequent  use  than  normally  of  the  commercial 
bill  carrying  modifying  clauses.  An  officer  in  one  of  the  largest  New 
York  banks  states  that  the  Foreign  Discount  Department  of  the 
bank  at  the  present  time  (1921)  uses  the  following  modifying  clauses 
when  negotiating  commercial  bills. 

Africa:  "Payable  with  exchange  as  per  endorsements  plus  English 
and  Colonial  stamps." 

Australia,  New  Zealand,  India:  "Payable  with  exchange  and  English 
and  Colonial  stamps  at  the  current  rate  for  negotiating  bills  in 
London  on  the  Colonies." 

China,  Japan,  Java:  "Payable  at  the  current  rate  of  exchange  for 
check  on  New  York  with  interest  at  seven  per  cent  per  annum 
from  date  hereof  until  approximate  date  of  arrival  of  cover  in  New 
York,  together  with  all  collection  charges  and  other  expenses." 

England,  Argentina,  France,  Italy,  Poland:  "Payable  at  the  current 
rate  of  exchange  for  approved  bankers'  check  on  New  York  to- 
gether with  interest  at  the  rate  of  six  per  cent  per  annum  from  the 
date  hereof  until  the  approximate  date  of  arrival  of  cover  in  New 
York." 

These  clauses  will  be  placed  upon  the  bill  by  the  bank  by  means  of 
a  rubber  stamp,  after  the  bill  has  been  taken  from  the  client  and  be 
fore  it  is  forwarded  for  presentment.  Advice  has  been  received, 
however,  that  in  at  least  one  South  American  country  (Uruguay) 
the  clause  will  be  held  invalid  if  stamped  upon  the  bill,  and  that  it 
must  !)e  incorporated  in  the  body  of  the  bill  if  it  is  to  be  binding  upon 
the  drawee.  The  practice  of  altering  the  terms  of  a  bill  by  the  bank- 
er's addition  of  "rubber  stamp"  clauses,  even  when  done  for  the 
purpose  of  conforming  to  the  varying  conditions  of  the  foreign  mar- 
kets, is  of  questionable  merit.    The  drawer  is  released  from  liability 


204  FOREIGN  EXCHANGE 

if  a  dishonored  draft  has  been  changed  by  the  addition  of  such 
clauses,  unless  the  banker  can  show  authorization.  The  safer  prac- 
tice would  seem  to  be  to  draw  the  drafts  in  the  first  instance  bear- 
ing the  necessary  clauses;  or,  else,  for  the  drawer,  after  acquainting 
himself  with  the  meaning  of,  and  necessity  for,  these  clauses,  to  give 
his  banker  authority  in  writing  to  make  the  required  additions. 


CHAPTER  VIII 

LETTERS  OF  CREDIT 

49.  Purpose  and  nature  of  letters  of  credit.  The  different 
types  of  commercial  bills  t'hus  far  discussed  have  had  one 
feature  in  common:  they  have  been  drawn  by  one  merchant 
upon  another  on  the  security  of  the  goods  which  were  chang- 
ing hands.  Reference  has  been  made  in  the  course  of  this 
discussion  to  a  somewhat  different  kind  of  commercial  bill  — 
one  drawn  by  the  seller  of  the  goods  upon  a  designated  banker 
whose  services  have  been  engaged  by  the  buyer  as  an  aid  in 
financing  the  transaction.  A  credit  may  be  defined  as  a  con- 
tract of  a  banker  to  place  a  specified  sum  at  the  disposal  of  a 
client,  subject  to  certain  requirements  stated  in  the  contract; 
the  authorization,  upon  the  strength  of  which  the  accredited 
party  draws  against  the  banker,  is  called  a  letter  of  credit. 

For  the  purpose  of  an  exporter,  a  draft  drawn  against  a 
banker  is  superior  to  one  drawn  upon  a  merchant,  because  of 
the  greater  ease  with  which  the  former  can  be  sold  and  the 
higher  and  more  stable  rate  which  it  commands.  In  buying 
commercial  long  bills,  bankers  express  their  faith  in  the  credit 
of  the  drawer,  relying  upon  him  to  make  good  any  default  of 
the  drawee;  only  to  a  secondary  degree  do  they  place  reliance 
in  the  security  of  the  goods  which  serve  as  collateral.  The 
risk  of  default  on  the  part  of  a  banker  is  ordinarily  much 
smaller  than  the  risk  of  default  by  a  merchant;  for  this 
reason,  bills  of  exchange  drawn  on  bankers  will  always  be 
bought  outright  from  the  drawer,  whereas  those  drawn  on 
merchants  may  be  taken  for  collection  only.  Moreover,  the 
banker's  purchase  price  for  a  commercial  long  bill  is  governed 
by  the  rate  of  discount  which  will  apply  to  it  when  sold  in  the 
foreign  market  after  acceptance,  and  bankers'  acceptances 
command  the  lowest  rates  of  discount.  Hence,  not  only  is  the 
exporter's  chance  of  disposing  of  his  bill  increased,  but  the 


206  FOREIGN  EXCHANGE 

price  he  receives  for  it  is  higher  when  it  is  drawn  upon  a  banK. 
When  a  foreign  customer  instructs  an  exporter  to  finance  a 
shipment  by  drawing  upon  a  designated  bank,  he  is  offering 
especially  favorable  terms  of  payment  and  can  expect  to  re- 
ceive as  a  concession  a  favorable  price  quotation;  thus  both 
buyer  and  seller  in  international  trade  find  in  the  bankers* 
acceptance  a  most  useful  financing  instrument. 

But  an  importer  who  instructs  his  foreign  creditor  to  draw 
against  a  bank  for  the  sale  price  of  the  goods  must  supply  his 
creditor  with  some  evidence  that  the  bank  has  agreed  to 
accept  the  draft.  It  is  a  prerequisite  of  the  transaction  from 
the  point  of  view  of  the  exporter  that  no  question  arise  as  to 
the  authority  under  which  he  places  the  bank  in  the  position 
of  drawee,  for  doubt  upon  this  point  would  debar  other 
bankers  from  handling  the  exporter's  bill.  If  the  bank  upon 
which  the  exporter  is  told  to  draw  is  located  in  his  own  coun- 
try, it  is  not  difficult  for  the  exporter  to  verify  his  privilege  of 
drawing  by  communicating  with  the  bank.  In  this  case,  the 
importer  who  has  opened  the  credit  for  the  benefit  of  the 
exporter  may  simply  write  the  latter  that  he  is  to  obtain  pay- 
ment for  his  goods  by  drawing  against  this  credit,  leaving  it 
to  the  exporter  to  assure  himself  of  his  position  before  parting 
with  the  merchandise.  But  when  the  accepting  bank  is  lo- 
cated outside  the  exporter's  country,  he  must  have  some 
guaranty  or  assurance  that  the  bank  is  cognizant  of  the  use  of 
its  credit  and  is  prepared  to  honor  the  draft  made  upon  it. 
The  commercial  letter  of  credit  is  a  document  which  gives  the 
exporter  this  assurance. 

50.  Commercial  letter  of  credit  issued  by  a  bank  upon  it- 
self. The  commercial  letter  of  credit  is  of  two  types:  in  its 
simpler  form,  it  is  a  written  authorization  issued  by  a  bank  to 
a  client  permitting  a  specified  beneficiary  to  draw  drafts  for  a 
stated  amount  upon  the  bank  itself.  The  second  form  is  some- 
what more  complex;  in  this  case,  the  bank  issues  a  letter  to  a 
client  which  authorizes  the  beneficiary  to  draw  drafts  for  a 
stated  amount  upon  another  bank,  usually  located  in  another 
country.  In  the  present  section  we  shall  discuss  the  simpler 
of  these  forms. 


LETTERS  OF  CREDIT  9P7 

FoBM  12.    Appucation  fob  Letter  of  Credit  (Boston  Bank) 

Boston ' 


Boston  Bank. 
Foreign  Department 

Import  Division 

Boston,  Mass. 
Dear  Sirs: 

Please  issue  an  Irrevocable  Letter  of  Credit  by       .. 

For  account  of 

In  favor  of 

Amount available  by  drafts  at 

against  documents  as  follows: 

Bills  of  lading  reading  Bills  of  Lading 

"Received  for  Shipment"  or       Invoice 
otherwise  worded  to  same  Consular  Invoice 

effect  are  acceptable  against 
this  credit. 

covering  ^^^  invoice  value  C.I.F.,  C.  &  F.,  F.O.B.,  F.A.S.  shipments. 

'5  /q  (Cross  out  all  but  one) 

to  be  shipped  from to 

Drafts  to  be  negotiated  on  or  before 

Insurance  to  be  effected  by 

Partial  shipments  are  to  be  permitted. 

Special  instructions 

The  letter  of  credit  is  subject  to  your  usual  terms  and  conditions, 
and  in  consideration  of  the  issuance  thereof  we  agree  to  reimburse 
you  on  demand,  and  we  hereby  authorize  you  to  charge  our  account 
with  any  and  all  amounts  for  which  you  are  liable  thereunder,  plus 
your  commission  and  charges. 

Neither  you  nor  your  correspondents  shall  be  responsible  for  the 
description,  quantity,  quality  or  value  of  the  merchandise  shipped 
under  this  credit,  nor  for  the  correctness,  genuineness  or  validity  of 
the  documents,  nor  for  delay  or  deviation  from  instructions  in  re- 
gard to  shipment,  nor  for  any  other  cause  beyond  your  control. 

Very  truly  yours. 


208  FOREIGN  EXCHANGE 

Let  us  assume,  by  way  of  illustration,  that  the  Massachu- 
setts Weaving  Company  has  placed  in  Japan  an  order  for  silk 
amounting  to  $100,000.  This  company  now  makes  applica- 
tion to  its  hank  in  Boston  for  a  letter  of  credit  which  will 
autliorize  the  Japanese  exporters  to  draw  a  draft  or  a  series 
of  drafts  upon  the  Boston  bank,  the  drafts  to  run  ninety  days 
from  acceptance.  This  application  is  made  on  a  special  form 
provided  by  the  bank.  A  specimen  of  a  typical  application  for 
a  letter  of  credit  is  given;'  the  reader  is  urged  to  examine  this 
document,  and  all  others  which  illustrate  the  text  of  this  chap- 
ter with  some  care,  since  it  is  only  in  this  way  that  the  nature 
of  these  transactions  can  be  made  clear. 

If  the  negotiation  for  the  letter  is  successful,  the  bank  will 
ask  the  company  to  sign  a  document  called  a  contract  for  the 
purchase  of  a  letter  of  credit,  setting  forth  the  terms  upon 
which  the  letter  is  granted.  A  specimen  of  this  contract  is 
given; 2  examination  shows  that  it  contains  the  following  prin- 
cipal provisions: 

(1)  The  Weaving  Company,  in  the  first  paragraph,  binds 
itself  to  provide  the  Boston  bank  with  funds  to  redeem 
each  bill  drawn  under  the  authority  of  the  letter  of 
credit,  before  the  maturity  of  the  bill. 

(2)  It  is  agreed  that  the  merchandise  imported  by  the  com- 
pany shall  be  the  property  of  the  bank,  until  all  obliga- 
tions of  the  company  to  the  bank  have  been  discharged. 
This  merchandise  is  to  be  insured  by  the  company  for 
the  benefit  of  the  bank.  It  is  to  be  held  subject  to 
seizure  and  sale  by  the  bank,  the  proceeds  to  be  applied 
to  the  redemption  of  the  bank's  acceptances  and  the 
payment  of  any  expenses  incurred.  Seizure,  however, 
does  not  release  the  company  from  its  obligation  to 
make  good  any  deficiency  in  the  proceeds  realized  from 
the  sale  to  discharge  the  company's  obligations  at  the 
bank. 

(3)  Under  certain  conditions  (such  as  a  falling  market  for 
the  merchandise)  the  bank  is  authorized  to  demand 
additional  collateral  security  from  the  company,  with 

»  See  Form  12,  page  207.  *  gee  Form  13,  page  210. 


LETTERS  OF  CREDIT  209 

power  to  seize  the  goods  if  the  additional  collateral  is 
not  supplied. 

(4)  All  obligations  of  the  company  to  the  bank  are  to  be- 
come due  and  payable  in  event  of  insolvency  by  the 
company. 

(5)  Provision  is  made  for  the  release  of  the  shipping  docu- 
ments in  advance  of  payment  under  a  trust  receipt, 
with  the  understanding  that  the  company  shall  support 
the  trust  receipt  by  depositing  collateral. 

(6)  The  commission  charges  of  the  bank  for  its  service  and 
other  miscellaneous  matters  are  covered  by  the  con- 
tract. 

(7)  Finally,  the  bank  in  an  important  clause  waives  all  ob- 
ligation to  guarantee  the  goods  in  any  respect  or  their 
date  of  shipment.  The  Japanese  exporters  may  send 
silk  of  a  poorer  quality  than  that  purchased,  or  may 
send  short  weight,  or  fail  to  deliver  according  to  agree- 
ment, but  none  of  these  contingencies  shall  alter  the 
obligations  of  the  Weaving  Company  to  the  bank.  It 
is  important  to  bear  this  fact  in  mind,  for  it  materially 
affects  the  usefulness  of  letters  of  credit  to  importers. 
In  essence,  the  effect  of  the  contract  upon  the  company 
is  to  compel  it  to  pay  the  specified  amounts,  regardless 
of  the  behavior  of  the  Japanese  exporters,  provided  the 
latter  draw  their  bills  in  proper  order  and  at  the  proper 
time. 

When  this  contract  has  been  drawn  up  and  signed,  the 
Boston  bank  issues  a  letter  of  credit  naming  the  Japanese 
exporters  as  beneficiaries.  Under  ordinary  conditions,  this 
letter  will  be  delivered  to  the  Weaving  Company  and  mailed 
by  them  to  the  exporters  in  Japan;  it  may,  however,  be  sent 
by  the  bank  to  the  exporters,  and,  if  time  is  pressing,  may  be 
replaced  by  a  cable  to  the  bank's  correspondent  in  Yokohama, 
instructing  the  latter  to  inform  the  exporters  of  their  right  to 
draw  against  the  Boston  bank.  Cabling  charges,  of  course, 
will  be  borne  by  the  Weaving  Company.  A  copy  of  a  typical 
letter  of  credit,  issued  by  an  American  bank  upon  itself,  is 


210  FOREIGN  EXCIIANGE 

Form  13 
Contract  fob  the  I*DBcaASE  of  DoUiAH  Import  Leitee  of  Credit 

Boston 


To  the  Boston  Bank. 
Dear  Sirs: 

Ilavingreceivedfromyou  the  Letter  of  Credit  No ,  we  hereby  agree  to  its  terms, 

and  in  consideration  thereof  we  agree  with  you  to  provide  in  Boston,  on  the  day  previous  to  the 
maturity  of  the  bills  drawn  in  virtue  thereof,  sufficient  funds  in  cash,  to  meet  the  payment  of  the 

same  with per  cent  commission,  and  we  undertake  to  insure  at  our  expense  for  your 

benefit,  against  risk  of  Fire  or  Sea,  all  property  purchased  or  shipped  pursuant  to  said  Letter  of 
Credit  in  companies  satisfactory  to  you. 

We  agree  that  the  title  to  all  property  which  shall  be  purchased  or  shipped  under  said  Credit, 
the  Bills  of  Lading  thereof,  the  Policies  of  Insurance  thereon,  and  the  whole  of  the  proceeds 
thereof,  shall  be  and  remain  in  you  until  the  payment  of  the  bills  referred  to  and  of  all  sums  that 
may  be  due  or  may  become  due  on  said  bills  or  otherwise,  and  until  the  payment  of  any  and  all 
other  indebtedness  and  liability  now  existing  or  hereafter  created  or  incurred  by  us  to  you  on 
any  and  all  other  transactions  now  or  hereafter  had  with  you,  with  authority  to  take  possession 
of  the  same  and  to  dispose  of  them  at  your  discretion  for  your  reimbursement  as  aforesaid,  at 
public  or  private  sale,  without  demand  or  notice,  and  to  charge  all  expenses,  including  com- 
mission for  sale  and  guarantee. 

Should  the  market  value  of  said  merchandise  in  Boston,  either  before  or  after  its  arrival, 
fall  so  that  the  net  proceeds  thereof  (all  expenses,  freight,  duties,  etc.,  being  deducted)  would  be 
insufficient  to  cover  your  advances  thereagainst  with  commission  and  interest,  we  further  agree 
to  give  you  on  demand  any  further  security  you  may  require,  and  in  default  of  same  you  shall 
be  entitled  to  sell  said  merchandise  forthwith,  or  to  sell  "  to  arrive,"  irrespective  of  the  maturity 
of  the  acceptances  under  this  Credit,  we  being  held  responsible  to  you  for  any  deficit  which  we 
bind  and  oblige  ourselves  to  pay  you  in  cash  on  demand. 

Incase  we  should  hereafter  desire  to  have  this  Credit  confirmed,  altered  or  extended  by  cable 
(which  will  be  at  our  expense  and  risk)  we  hereby  agree  to  hold  you  harmless  and  free  from  re- 
sponsibility from  errors  in  cabling,  whether  on  the  part  of  yourselves  or  your  Agents,  here  or 
elsewhere,  or  on  the  part  of  the  cable  companies. 

This  obligation  is  to  continue  in  force,  and  to  be  applicable  to  all  transactions,  notwithstand- 
ing any  change  in  the  composition  of  the  firm  or  firms,  parties  to  this  contract  or  in  the  user 
of  this  Credit,  whether  such  change  shall  arise  from  the  accession  of  one  or  more  new  partners, 
or  from  the  death  or  secession  of  any  partner  or  partners. 

It  is  understood  and  agreed  that  if  the  documents  representing  the  property  for  which  this 
Credit  has  been  issued  are  surrendered  under  a  trust  receipt,  collateral  security  satisfactory  to  tha 
Boston  Bank,  such  as  stocks,  bonds,  warehouse  receipts,  or  other  security  shall  be  given  to 
the  Trust  Company,  to  be  held  until  the  terms  of  the  credit  have  been  fully  satisfied  and  subject 
in  every  respect  to  the  conditions  of  this  agreement. 

It  is  further  agreed  and  understood  in  the  event  of  any  suspension,  or  failure,  or  assign- 
ment for  the  benefit  of  creditors  on  our  part,  or  of  the  nonpayment  at  maturity  of  any  accept- 
ance made  by  us,  or  of  any  indebtedness  or  liability  on  our  part  to  you,  all  obligations,  accept- 
ances, indebtedness  and  liabilities  whatsoever  shall  thereupon,  at  your  option  then  or  there- 
after exercised,  without  notice  mature  and  become  due  and  payable. 

It  Is  understood  and  agreed  that  you  and  your  correspondents  shall  not  be  held  responsible 
for  the  correctness  or  validity  of  the  documents  representing  shipment  or  shipments,  nor  for  the 
description,  quantities,  quality  or  value  of  the  merchandise  declared  therein. 


LETTERS  OF  CREDIT  £11 

given  ;^  it  will  be  seen  that  the  principal  features  are  the 
following: 

(1)  In  the  body  of  the  letter  the  Japanese  exporters  are 
formally  notified  of  their  right  to  draw  against  the 
Boston  bank  for  a  total  of  $100,000.  Instructions  are 
given  regarding  the  form  of  the  drafts  and  the  docu- 
ments which  must  accompany  them.  The  shipping 
documents  are  the  same  as  those  described  in  the  pre- 
ceding chapter  —  bill  of  lading,  invoices,  and  insurance 
policy.  Each  draft  must  bear  on  its  face  evidence  that 
it  was  drawn  under  the  letter  of  credit.  These  prescrip- 
tions must  be  carefully  observed  by  the  Japanese  ex- 
porters, for  no  banker  will  negotiate  bills  under  the 
authority  of  the  letter  of  credit  which  do  not  in  every 
detail  conform  to  the  regulations  laid  down  by  the 
letter. 

(2)  The  rest  of  the  letter  is  addressed  to  foreign  bankers 
who  are  asked  to  buy  the  bills  drawn  under  the  letter. 
The  Boston  bank  formally  obligates  itself  to  honor  all 
drafts  drawn  to  conform  to  the  terms  of  the  letter,  if 
drawn  before  a  certain  date.  Negotiating  bankers  are  in- 
structed to  endorse  on  the  back  of  the  letter  the  amount 
of  each  draft  and  the  date  of  negotiation,  and  to  send 
directly  to  the  Boston  bank  a  copy  of  the  bill  of  lading 
and  the  consular  invoice  which  is  attached  to  the  draft. 

With  this  authorization  in  hand,  the  Japanese  exporters  can 
ship  the  silk  either  in  one  or  a  number  of  lots,  drawing  for  the 
value  of  each  shipment  against  the  Boston  bank.  To  each 
draft  is  attached  the  bill  of  lading  and  other  required  docu- 
ments and  the  resulting  documentary  commercial  bill  is 
offered  for  sale  to  a  Japanese  banker,  the  letter  of  credit  serv- 
ing as  an  assurance  to  the  banker  that  the  transaction  is  bona 
fide.  Since  the  draft,  when  it  reaches  Boston,  will  become  a 
banker's  acceptance  and  hence  a  credit  instrument  of  high 
grade,  the  Japanese  bank  will  not  hesitate  to  buy  it  outright, 
paying  the  exporters  in  Japanese  money  the  value  of  the  silk 
they  have  shipped.  The  bill  is  then  sent  by  the  purchaser  to 
'  See  Form  14,  page  Hi. 


212  FOREIGN  EXCHANGE 

FonM  It.    Import  Letter  of  Credit  (Dolllars) 
Credit  No.  100 


For    $100,000  —  U.S.C. 

Japanese  Exporters 

Yokohama,  Japan 


Boston  Bank 
Torcign  Department 

Boston        July  1, 1921 


Dear  Sirs: 

At  the  request  of        Massachusetts  Weaving  Company        we 

hereby  authorize  you  to  value  on  Boston  Bank,  Boston,  Mass.,  by  your 
drafts  at        three  (3)  months  sight  for  any  sum  or  sums  not  exceeding 

a  total  of            one  hundred  thousand  dollars              accompanied  by  com- 
mercial invoice,  consular  invoice,  bills  of  lading  representing 

shipment  of  raw  silk  from  Yokohama  to  Boston 


Insiu-ance  marine,  to  be  effected  by  shippers 


Bills  of  lading  for  such  shipments  must  be  dra^Ti  to  the  order  of  the  Boston 
Bank  of  Boston  imless  otherwise  specified  in  this  credit. 

A  COPT  OF  THE  CONSULAR  INVOICE  AND  ONE  BILL  OF  LADING  MUST  BE 
BENT     BY    THE     BANK     OR     BANKER    NEGOTIATING     DRAFTS,    DIRECT    TO    THE 

Boston  Bank,  Boston,  U.S.A. 

The  amount  of  each  draft  negotiated  together  with  the  date  o» 
negotiation  must  be  endorsed  hereon. 

We  hereby  agree  with  bona  fide  holders  that  all  drafts  drawn  by  virtue 
of  this  credit,  and  in  accordance  with  the  above  stipulated  terms,  shall 
be  honored  upon  presentation  at  the  Boston  Bank  if  drawn  and  negotiated 
on  or  before  October  1,  1921 

N.B.  All  drafts  drawn  under  this  credit    Boston  Bane 
must  bear  clause  "  drawn  under  Bos- 
ton Bank  Letter  of  Credit  No.    100  « 


dated  Boston       July  1,  1921         to 

cover  shipment  of  Raw  Silk     from 

Yokohama        to        Boston 


LETTERS  OF  CREDIT  21S 

a  correspondent  bank  in  Boston  to  be  presented  for  accept- 
ance to  the  Boston  bank  upon  which  it  is  drawn;  it  will  allow 
delivery  of  the  documents  against  acceptance.  When  pre- 
sentment is  made,  the  Boston  bank  will  examine  the  docu- 
ments to  see  that  they  conform  to  the  requirements  of  the 
letter  of  credit;  if  satisfied  upon  this  point,  it  will  accept  the 
draft  and  return  it  to  the  presenting  banker,  detaching  and 
retaining  the  documents.  The  transaction  then  divides  into 
two  parts.  The  bill  of  exchange  is  now  held  in  Boston  for  the 
account  of  the  Japanese  bank;  being  a  banker's  acceptance 
of  ninety  days'  usance,  it  may  be  sold  in  the  discount  market, 
thus  recovering  for  its  owner  the  money  invested  in  it.  We 
need  not  now  inquire  into  the  motives  which  induce  a  Japan- 
ese bank  to  create  such  funds  in  Boston,  nor  into  the  uses  to 
which  it  intends  to  put  the  proceeds  of  the  sale  of  the  accept- 
ance. The  acceptance  will  find  its  way  into  the  hands  of 
some  investor  in  the  discount  market,  where  it  will  remain 
until  maturity,  when  it  wnll  be  presented  to  the  Boston  bank 
for  redemption.  By  the  terms  of  the  contract  for  the  letter  of 
credit,  the  Weaving  Company  is  bound  to  deposit  with  the 
bank  funds  sufficient  to  redeem  the  acceptance  some  days  be- 
fore the  date  of  maturity. 

The  second  phase  of  the  transaction  concerns  the  relations 
of  the  Weaving  Company  with  the  bank.  The  bill  of  lading 
and  other  documents  were  retained  by  the  bank  when  the 
draft  was  accepted.  In  due  course,  the  silk  w^ill  arrive  in  the 
harbor,  and  the  Weaving  Company  will  wish  to  make  some 
arrangement  by  means  of  which  it  can  obtain  possession  of 
the  goods.  In  extreme  cases,  it  may  find  itself  unable  to 
make  any  arrangement  more  satisfactory  than  a  cash  prepay- 
ment of  the  acceptance;  but  this  method  is  not  very  practi- 
cable where  the  acceptance  has  been  sold  in  the  discount  mar- 
ket and  its  present  owner  is  unknown.  Moreover,  unless  the 
company's  credit  is  unusually  poor,  the  bank  will  give  up  the 
bill  of  lading  under  the  protection  of  a  trust  receipt.  The  sur- 
render of  merchandise  collateral  against  a  trust  receipt  is  a 
common  practice  with  American  banks,  a  practice  which  con- 
trasts with  the  attitude  of  suspicion  taken  toward  the  method 


2U  FOREIGN  EXCHANGE 

by  the  banks  of  England  and  other  countries.  The  trust 
receipt,  to  be  adaptable  to  the  purposes  of  the  company, 
must  be  drawn  in  such  form  as  to  allow  the  goods  to  be  proc- 
essed and  sold  while  in  the  company's  possession;  a  copy  of 
such  a  trust  receipt  is  given  on  page  182;  it  provides  for  the 
treatment  of  the  goods,  and  their  sale,  by  the  company,  at 
the  same  time  continuing  the  ownership  in  them  by  the  bank, 
and  obligating  the  company  to  turn  over  all  proceeds  of  their 
sale  to  be  applied  against  its  debt  to  the  bank.  W  hether  or 
not  the  company  completes  its  sale  of  the  silk,  it  is  bound  by 
the  contract  to  cover  the  draft  before  it  falls  due,  and  this 
obligation  it  cannot  avoid  otherwise  than  by  declaring  itself 
insolvent. 

In  recent  years,  the  proportion  of  our  import  trade  financed 
by  the  type  of  letter  of  credit  just  described  has  been  in- 
creasing rapidly,  as  a  result  of  the  Great  War  and  of  the  de- 
velopment of  the  banking  structure  of  the  United  States.  It 
is  impossible  to  say  with  assurance  whether  this  type  of  letter 
w^ill  become,  in  the  future,  a  customary  financing  instrument 
among  American  importers,  but  certain  conditions  may  be 
laid  down  as  governing  the  extension  of  its  use.  It  wnll  be- 
come apparent,  when  reflecting  upon  the  motives  which 
determine  the  choice  of  financing  instruments  by  merchants, 
that  letters  of  credit  issued  by  our  banks  upon  themselves 
will  be  used  only  within  the  limits  set  by  the  salability  of 
dollar  bills  to  the  bankers  in  foreign  centers.  Exporters  of 
silk  from  Japan,  to  revert  to  our  illustration,  will  certainly 
wish  to  draw  bills  which  Japanese  bankers  are  ready  to  buy; 
a  letter  of  credit  issued  by  an  American  bank  upon  itself  will 
result  in  the  drawing  of  long  dollar  bills,  and  these,  when 
bought  by  Japanese  bankers,  will  result  in  the  accumulation 
of  funds  in  American  money  centers.  The  willingness  of 
Japanese  and  other  foreign  bankers  to  buy  these  bills  from 
their  clients  will  depend  upon  a  number  of  factors,  chief 
among  which  are:  first,  the  perfection  of  the  discount  market 
in  American  as  compared  with  London  and  other  centers,  for 
ability  to  discount  the  bill  is  an  essential  condition  to  the 
banker's  purchase;  second,  the  opportunities  which  these 


LETTERS  OF  CREDIT  215 

bankers  have  of  utilizing  funds  in  American  cities  —  that  is 
to  say,  the  demand  in  their  market  for  bankers'  drafts  drawn 
in  dollars.  Given  marketability  of  dollar  drafts  equal  to  that 
of  drafts  in  other  moneys,  foreign  exporters  will  still  refuse  to 
draw  them  unless  they  can  be  sold  at  favorable  prices,  and 
this  matter  will  be  determined  by  the  discount  rate  in  the 
open  money  markets  of  American  as  compared  with  the  rates 
in  other  centers.  Under  the  conditions  which  long  obtained 
before  the  Great  War,  these  long  dollar  bills  drawn  on  Amer- 
ican bankers  were  not  used.  The  premier  place  among 
financing  instruments  in  foreign  trade  was  held  by  sterling 
exchange;  these  could  be  sold  everywhere  and  at  the  most 
favorable  rates.  When  conditions  are  again  normal,  it  may 
be  found  that  most  of  the  letters  of  credit  issued  to  American 
importers  call  for  the  drawing  of  drafts,  not  against  the  issu- 
ing bank  in  America,  but  against  some  bank  in  London.  We 
shall  now  turn  to  a  description  of  such  a  letter. 

51.  Letter  of  credit  issued  upon  a  second  bank.  The  es- 
sentials of  the  transaction  we  are  about  to  consider  are  these: 
the  clients  of  an  American  bank  require  power  to  instruct  for- 
eign exporters  to  draw  against  a  banking  house  in  London; 
the  American  bank  can  bestow  this  power,  provided  it  has 
previously  received  the  London  bank's  agreement  to  accept 
the  drafts  drawn.  Accordingly,  we  separate  the  operations 
involved  in  the  issue  of  a  letter  of  credit  by  an  American  bank 
upon  an  English  bank  into  three  phases: 

(a)  The  arranging  of  terms  between  the  two  banks  which 
bind  the  English  bank  to  accept  drafts  drawn  in  pounds 
"sterling  under  the  authority  of  a  letter  of  credit  to  be 
issued  by  the  American  bank. 

(6)  The  agreement  between  the  American  importer  and  the 
American  bank  concerning  the  terms  upon  which  the 
latter  will  exercise  its  power  to  issue  to  the  former  a  let- 
ter of  credit  against  the  bank  in  London. 

(c)  The  drawing  of  sterling  bills  by  the  foreign  exporter 
and  the  handhng  of  these  bills  in  the  exchange  markets. 

(a)  The  acceptance  agreement  between  the  two  banks.  The 
banks  in  question  will  be  correspondents,  the  one  located  in 


216  FOREIGN  EXCHANGE 

London,  the  other  in  America;  the  arrangement  between  them 
concerning  the  letter  of  credit  will  involve  the  establishment 
and  maintenance  of  an  acceptance  account  by  the  London 
bank  in  favor  of  the  American.  All  acceptances  performed 
by  the  London  bank  will  be  charged  immediately  to  this  ac- 
count, and  all  maturities,  when  redeemed  out  of  the  cash 
balance  which  the  American  bank  maintains  with  its  London 
correspondent,  will  be  removed  from  the  acceptance  account. 
At  any  moment,  therefore,  the  acceptance  account  will  show 
the  total  of  the  bills  outstanding  and  the  dates  upon  which 
they  will  mature.  The  American  bank  is  bound  by  the  agree- 
ment to  deposit  funds  for  the  redemption  of  every  accept- 
ance, for  it  is  not  the  intention  of  the  London  bank  to  expend 
any  of  its  own  cash  in  connection  with  the  transactions  which 
arise  under  the  letter  of  credit,  but  only  to  lend  its  credit,  or, 
in  other  words,  the  use  of  its  name  as  acceptor,  with  the  mi- 
derstanding  that  all  payments  will  be  borne  by  the  American 
correspondent. 

It  should  be  apparent,  however,  that  the  London  bank  can- 
not open  an  acceptance  account  without  some  risk  to  itself. 
In  the  eyes  of  the  law,  all  acceptances  which  it  makes  are 
binding  liabilities,  in  no  way  contingent  upon  the  performance 
by  the  American  bank  of  its  part  of  the  contract;  upon  ma- 
turity, they  will  be  presented  to  the  acceptor  for  redemption 
and  redemption  cannot  be  postponed  without  acknowledg- 
ment of  insolvency  by  the  London  bank.  This  risk  is  so  great 
that  the  American  bank  can  properly  be  required  to  secure  its 
London  correspondent  against  loss,  and  so  the  acceptance 
account  is  usuaUy  hedged  about  by  two  restrictions:  (1)  a 
maximum  amount  is  established  and  the  American  bank  is 
debarred  from  granting  credits  in  excess  of  this  amount;  (2) 
collateral  security  equal  to  the  value  of  this  maximum  credit 
is  placed  in  the  hands  of  the  London  bank  to  be  used  when- 
ever the  cash  balance  of  the  American  correspondent  is  in- 
sufficient to  redeem  any  acceptances  when  they  mature.  Ex- 
ceptions to  these  rules  are  not  lacking.  Banks  whose  asso- 
ciations have  been  of  long  standing  and  free  from  all  evidence 
of  bad  faith  will  sometimes  create  acceptance  accounts  to 


LETTERS  OF  CREDIT  217 

which  no  formal  restrictions  apply,  the  American  bank  being 
left  free  to  issue  letters  of  credit  to  any  amount  within 
reason,  without  the  deposit  of  collateral  of  any  kind.  But 
such  cases  are  rare;  the  London  bank  in  undertaking  to  ac- 
cept drafts  under  powers  granted  by  the  American  bank  is 
bearing  the  risk,  not  only  of  bad  faith,  but  of  business  re- 
verses which  may  cause  the  failure  of  the  American  bank 
while  some  of  the  acceptances  are  outstanding. 

The  London  bank  will  charge  a  commission  for  the  service 
it  renders  as  acceptor.  This  commission  varies  rather  widely 
as  between  different  correspondents,  being  based  somewhat 
upon  the  volume  of  business  of  other  kinds  which  the  Ameri- 
can bank  provides,  the  amount  of  cash  it  customarily  keeps 
on  deposit,  and,  in  general,  the  profit  which  the  London  bank 
can  derive  from  the  position  of  correspondent.  In  any  case, 
the  scale  of  rates  will  be  adjusted  to  the  length  of  life  of  the 
drafts  which  are  drawn  under  the  letter  of  credit.  The  fol- 
lowing is  a  typical  system  of  commission  charges: 

Charges  of  London  Banks  for  Accepting  Sterling  Drafts 
UNDEiR  Letter  of  Credit 

per  cent 

Sight  drafts 1/8  to  1/4 

30  days'  sight 1/4  to  3/8 

60  days'  sight 3/8  to  1/2 

90  days'  sight 1/2  to  5/8 

4  months 5/8  to  7/8 

6  months 7/8  to  1 

This  proportioning  of  the  commission  charges  to  the  usance 
of  the  draft  is  accounted  for  by  the  fact  mentioned  above; 
namely  that  in  accepting  a  draft  for  the  account  of  a  cor- 
respondent, the  London  bank  is  venturing  its  credit  against 
the  chance  of  failure  by  the  American  bank  before  the  draft 
matures.  The  longer  the  lapse  of  time  between  acceptance 
and  maturity,  the  greater  the  chance  that  some  calamity  will 
intervene  to  prevent  the  American  bank  from  performing  its 
obligation  to  supply  the  acceptor  with  funds  for  redemption. 
The  rising  scale  of  commission  cliarges  is,  therefore,  a  measure 
of  the  increasing  risk  which  the  acceptor  bears. 


218  FOREIGN  EXCHANGE 

Form  15.   Sterling  Import  Letter  of  Credit  Agreement 

Boston 


To  the 

BOSTON  BANK 

Gentlemen: 

Letter  of  credit  having  been  issued  at  mv/our  request,  I/we 
hereby  agree  to  its  terms,  and  in  consideration  thereof,  I/we  agree 
with  you  to  provide  in  Boston,  at  such  time  previous  to  the  Maturity 
of  the  Bills  drawn  in  virtue  thereof,  as  may  be  decided  by  you,  suffi- 
cient funds  in  cash,  or  in  Bills  on  London,  satisfactory  to  you  and 

endorsed  by  me/ us  to  meet  the  payment  of  the  same  with 

....  per  cent  commission  and  interest  as  hereinafter  provided,  and 
I/we  undertake  to  insure  at  my /our  expense,  for  your  benefit,  against 
risk  of  fire  or  sea,  all  property  purchased  or  shipped  pursuant  to  said 
Letter  of  Credit,  in  companies  satisfactory  to  you. 

I/we  agree  that  the  title  to  all  property  which  shall  be  purchased 
or  shipped  under  the  said  credit,  the  bills  of  lading  thereof,  the  pol- 
icies of  insurance  thereon  and  the  whole  of  the  proceeds  thereof,  shall 
be  and  remain  in  you  until  the  payment  of  the  bills  referred  to  and  of 
all  sums  that  may  be  due  or  that  may  become  due  on  said  bills  or, 
otherwise,  and  until  the  payment  of  any  and  all  liabilities  and  in- 
debtedness now  existing  or  now  or  hereafter  created  or  incurred 
by  me/us  to  you  on  any  and  all  other  transactions  now  or  here- 
after had  with  you,  with  authority  to  take  possession  of  the  same 
and  to  dispose  thereof  at  your  discretion  for  your  reimbursement  as 
aforesaid,  at  public  or  private  sale,  without  demand  or  notice,  and 
to  charge  all  expenses,  including  commission  for  sale  and  guarantee. 

Should  the  market  value  of  said  merchandise  in  Boston,  either 
before  or  after  its  arrival  fall  so  that  the  net  proceeds  thereof  (all 
expenses,  freights,  duties,  etc.,  being  deducted)  would  be  insufficient 
to  cover  your  advances  thereagainst  with  commission  and  interest 
I/we  further  agree  to  give  you  on  demand  any  further  security  you 
may  require,  and  in  default  thereof  you  shall  be  entitled  to  sell  said 
merchandise  forthwith,  or  to  sell  "to  arrive"  irrespective  of  the  ma- 
turity of  the  acceptances  under  this  credit,  I/we  being  respon- 
sible to  you  for  any  deficit,  which  I/we  bind  and  oblige  myself/ 
ourselves  to  pay  you  in  cash  on  demand. 

It  is  luiderstood  that  in  all  payments  made  by  me/us  to  you  in  the 


LETTERS  OF  CREDIT  219 

United  States,  the  Pound  Sterling  shall  be  calculated  at  the  current 
rate  of  exchange  for  Bankers'  bills  in  Boston  on  London  existing  at 
the  time  of  settlement,  and  that  interest,  if  any,  shall  be  charged  at 
the  rate  for  overdrafts  current  in  London,  at  the  time  of  settlement. 

Should  I/we  anticipate  the  payment  of  any  portion  of  the  amount 
payable,  interest  is  to  be  allowed  at  a  rate  to  be  fixed  by  you. 

In  case  I/we  should  hereafter  desire  to  have  this  credit  confirmed 
or  extended  by  cable  (which  will  be  at  my /our  expense  and  risk),  I/we 
hereby  agree  to  hold  you  harmless  and  free  from  responsibility  from 
all  errors  in  cabling,  whether  on  the  part  of  yourselves  or  your 
agents,  here  or  elsewhere,  or  on  the  part  of  the  cable  companies. 

This  obligation  is  to  continue  in  force,  and  to  be  applicable  to  all 
transactions,  notwithstanding  any  change  in  the  composition  of  the 
firm  or  firms,  parties  to  this  contract,  or  in  the  user  of  this  credit, 
whether  such  change  shall  arise  from  the  accession  of  one  or  more  new 
partners,  or  from  the  death  or  secession  of  any  partner  or  partners. 

It  is  understood  that  if  the  documents  representing  the  property 
for  which  the  said  credit  has  been  issued  are  surrendered  under  a 
trust  receipt,  collateral  security  satisfactory  to  the  Boston  Bank, 
such  as  stocks,  bonds,  warehouse  receipts  or  other  security,  shall  be 
given  to  the  Bank  to  be  held  until  the  terms  of  the  credit  have  been 
fully  satisfied  and  subject  in  every  respect  to  the  conditions  of  this 
agreement. 

It  is  further  understood  in  the  event  of  any  suspension,  or  failure, 
or  assignment  for  the  benefit  of  creditors  on  my /our  part,  or  of  the 
nonpayment  at  maturity  of  any  acceptances  made  by  me/us,  or 
of  the  nonfulfillment  of  any  obligation  under  said  credit  or  under 
any  other  credit  issued  by  the  Boston  Bank  on  my/our  account, 
or  of  any  indebtedness  or  liability  on  my /our  part  to  you,  all  ob- 
ligations, acceptances,  indebtedness  and  liabilities  whatsoever  shall 
thereupon,  at  your  option,  then  or  thereafter  exercised,  without 
notice,  mature  and  become  due  and  payable. 

It  is  understood  that  you  and  your  correspondents  shall  not  be 
held  responsible  for  the  correctness  or  validity  of  the  documents  rep- 
resenting shipment  or  shipments,  nor  for  the  description,  quan- 
tities or  quality  of  the  merchandise  declared  therein. 


220  FOREIGN  EXCHANGE 

(b)  Conditions  of  sale  of  the  letter  of  credit.  The  terms  upon 
which  an  acceptance  account  is  established  with  a  London 
correspondent  have  just  been  described;  they  may  be  summed 
up  in  tlie  statement  that  the  American  bank  promises  to  re- 
deem all  sterling  bills  charged  to  the  acceptance  account,  usu- 
ally supporting  its  promise  by  a  deposit  of  collateral  security; 
and  agrees  to  pay  a  certain  commission  charge  for  the  services 
of  the  London  bank.  In  issuing  a  letter  of  credit  to  a  client, 
the  American  bank  will  virtually  assign  a  portion  of  its  power 
to  draw  sterling  bills,  without,  however,  diminishing  its  own 
liability  under  the  terms  of  the  acceptance  agreement.  We 
may  expect,  therefore,  that  the  letter  will  not  be  issued  until 
the  client  has  acceded  to  terms  at  least  as  stringent  as  those 
demanded  of  the  bank  by  its  London  correspondent,  terms 
which  will  pass  on  to  the  client  the  obligation  to  supply  funds 
for  the  redemption  of  all  drafts  drawn,  and  also  the  expense 
of  maintaining  the  acceptance  account  in  London.  These 
terms  of  sale  for  the  letter  of  credit  will  be  adjusted  to  the 
conditions  of  each  individual  transaction  and  will  very  nat- 
urally differ,  as  the  banker's  willingness  to  grant  the  credit 
varies  with  the  standing  of  the  client  and  the  character  of  the 
commercial  operation  to  which  he  intends  to  devote  the  power 
granted  him  by  the  banker.  When  approached  with  a  re- 
quest for  a  letter  of  credit,  the  banker's  first  inquiry  will  be 
—  assuming,  of  course,  that  the  client  is  not  disqualified  by 
an  unfavorable  reputation  —  concerning  the  details  of  the 
transaction  which  is  contemplated,  the  nature  of  the  goods  to 
be  imported,  and  the  prospects  for  a  profitable  sale  in  this 
country;  for  the  goods  will  be  used  as  security  by  the  banker 
and  must  answer  the  requirements  of  collateral  security  — 
salability  and  freedom  from  the  risk  of  deterioration.  Satis- 
fied with  the  transaction,  the  banker  will  require  further  that 
the  client  give  assurance  of  his  financial  stability,  usually  by 
exhibiting  a  statement  of  the  condition  of  his  business,  though 
this  assurance  may  be  taken  for  granted  in  the  case  of  busi- 
ness men  with  whom  the  banker  has  had  long  acquaintance. 

If  the  letter  of  credit  is  issued,  the  client  will  be  called  upon 
to  sign  a  contract  similar  to  the  one  given.  ^  This  contract  is 
1  See  Form  15,  page  218. 


LETTERS  OF  CREDIT  221 

in  many  respects  identical  with  that  used  when  the  letter  of 
credit  is  issued  by  the  bank  upon  itself;  examination  discloses 
the  following  additional  features: 

(1)  The  funds  which  the  client  agrees  to  supply  for  the  re- 
demption of  the  acceptances  are  to  be  in  the  form  of 
sterling  demand  drafts  or  the  equivalent  of  these  drafts 
in  American  money.  This  is  because  the  bank  which 
issues  the  credit  is  obliged  to  cover  the  London  bank's 
acceptances  in  sterling  demand  drafts  and  it  merely 
passes  this  obligation  on  to  the  client  on  whose  behalf 
the  letter  is  issued. 

(2)  In  this  contract,  it  is  provided  that  the  client  shall  have 
the  option  of  prepaying  his  obligations  and  the  rate  of 
interest  allowed  for  prepayment  is  specified.  This  pro- 
vision is  sometimes  included  in  agreements  regarding 
dollar  letters  of  credit,  but  did  not  appear  in  the  speci- 
men used  by  us  in  the  preceding  illustration. 

The  letter  of  credit,  itself,  will  be  addressed  to  the  foreign 
exporter  apprising  him  of  his  power  to  draw  sterling  bills  of  a 
certain  tenor  and  to  a  specified  amount  upon  the  London 
bank;  the  form  of  these  drafts  will  be  prescribed — docu- 
mentary drafts  of  the  usual  type,  each  bearing  upon  its  face 
evidence  that  it  was  drawn  under  the  letter  of  credit  and  for 
the  purpose  of  financing  a  specified  transaction.  The  letter, 
also,  will  contain  clauses  for  the  information  of  foreign  bank- 
ers who  are  called  upon  to  negotiate  these  drafts,  instructing 
them  to  endorse  the  amount  of  each  draft  upon  the  back  of  the 
letter,  together  with  the  date  of  negotiation,  and  to  send  a 
copy  of  the  invoice  and  bills  of  lading  to  the  Boston  bank. 
Under  these  conditions,  foreign  bankers  are  assured  that  the 
drafts  will  be  honored  by  the  British  Foreign  Bank  of  London. 

It  is  customary  for  the  exporter,  who  is  to  be  the  beneficiary 
of  the  letter  of  credit,  to  insist  that  the  letter  be  irrevocable. 
An  irrevocable  letter  cannot  be  recalled  when  once  issued,  so 
long  as  its  terms  are  observed;  accordingly,  the  exporter,  when 
in  possession  of  an  irrevocable  letter  of  credit,  may  proceed  to 
fill  his  customer's  order  for  goods  even  though  this  requires 
manufacture  or  expenditure  of  money  on  his  part  for  other 


222  FOREIGN  EXCHANGE 

jnirposes,  in  the  assurance  that  the  credit  which  has  lieen  es- 
tahHshed  in  his  favor  will  not  suddenly  be  recalled  before  he 
has  time  to  recoup  his  expenses.  In  some  cases,  however,  the 
bank  expressly  retains  the  right  to  revoke  the  letter,  though 
it  can  exercise  this  right  only  by  giving  advance  notice  to  the 
parties  concerned  and  cannot  make  the  revocation  retro- 
active so  as  to  apply  to  any  drafts  drawn  before  the  notice  of 
revocation  reaches  the  drawer.  Whether  irrevocable  or  not, 
the  letter  of  credit  will  hold  good  only  for  a  definite  period  of 
time,  the  date  upon  which  it  becomes  void  being  plainly 
stated  on  its  face  as  a  warning  of  this  condition  to  any  one  to 
whom  it  is  exhibited.  The  foregoing  description  of  the  letter 
of  credit  may  be  illustrated  by  a  copy  of  a  typical  letter  which 
appears  on  page  223. 

The  American  bank  will  notify  its  London  correspondent 
each  time  a  letter  of  credit  is  issued  against  the  acceptance 
account,  stating  the  definitive  number  of  the  letter  and  de- 
scribing its  terms.  Up  to  this  point  in  the  transaction,  the 
accepting  bank  has  done  nothing  to  give  the  exporter,  benefi- 
ciary of  the  letter,  legal  power  to  enforce  the  acceptance  of 
drafts  drawn  upon  it.  No  contract  exists  between  the  drawer 
and  this  bank;  the  obhgations  of  the  bank  lie  solely  between 
itself  and  the  American  correspondent  under  the  terms  of  the 
acceptance  agreement.  The  exporter's  only  assurance  that 
his  drafts  will  be  honored  rests  upon  his  possession  of  the 
letter  of  credit,  and  this,  it  should  be  recalled,  has  been  is- 
sued, not  by  the  accepting  bank,  but  by  the  importer's  banker 
in  America.  Now,  although  in  the  practice  of  international 
commerce  the  risk  of  non-acceptance  is  shght,  whatever  risk 
exists  must  be  borne  by  the  exporter  who  will  be  expected  to 
part  wnth  his  goods  in  a  belief  that  his  drafts  will  be  accepted. 
If  non-acceptance  occurs,  the  exporter  will  be  obliged  to  re- 
turn to  his  banker  all  funds  advanced  him  on  bills  of  exchange 
which  are  returned  unaccepted  and  he  must  then  depend  upon 
action  brought  against  the  American  bank  to  recover  his  loss. 
It  is  the  privilege  of  the  exporter  to  refuse  to  bear  this  risk,  in 
which  case,  if  the  transaction  is  to  take  place,  the  importer 
must  have  the  letter  of  credit  confirmed  by  the  London  bank 


LETTERS  OF  CREDIT  223 

FoHM  16.  Import  Letter  of  Credit  (Pounds  Sterlinq) 

Credit  No.       100  _  _^ 

Boston  Bank 

Foreign  Department 

For        £20,000 

Boston      July  1,1921 


Japanese  Exporters 

Yolcohaina,  Japan 

Dear  Sirs: 
At  the  request  of  Massachusetts  WeavmgCompany^ 

we  hereby  authorize  you  to  value  on 

British  FoBEiaN  Bank,  Limited,  London 

by  your  drafts  at         three  (3)  months  sight  for  any  sum  or  sums  not  exceeding  a  total  of 

twenty  thousand  pounds  sterling  accompanied  by  commercial  invoice,  consular 

invoice,  bills  of  lading,  representing shipment  of 

raw  silk  from  Yokohama  to  Boston 

Insurance         Marine  to  be  effected  by  the  shippers 


Bills  of  lading  for  such  shipments  must  be  drawn  to  the  order  of  the  Boston  Bank  unless 
otherwise  specified  in  this  credit. 

A  COMMERCIAL  INVOICE,  CERTIFIED  COPY  OF  THE  CONSULAR  INVOICE  AND  ONE  BILL  OF  LAD- 
ING MUST  BE  SENT  DIRECT  TO  THE  BosTON  BaNK,  BoSTON,  U.S.A.,  BY  THE  NEGOTIATING  BANK 
WHOSE  CERTIFICATE  TO  THAT  EFFECT  TOGETHER  WITH  THE  REMAINING  DOCUMENTS  MUST  ACCOM- 
PANY YOUR  DRAFT. 

The  AMOUNT  of  each  draft  negotiated  together  WITH  THE  DATE  OF  NEGOTIATION  MOST 
BE  ENDORSED  HEREON. 

We  agree  with  bona  fide  holders  that  all  drafts  drawn  by  virtue  of  this  Credit,  and  in  accord- 
ance with  the  above  stipulated  terms,  shall  meet  with  due  honor  upon  presentation  at  the 
British  Foreign  Bank,  Limited,  London,  England,  if  drawn  and  negotiated  on  or  before 
October  1,  19^21 

N.B.  All  drafts  drawn  under  this  Credit                          Boston  Bank 
must  bear  the  clause  "drawn  under  Bos- 
.  ton  Bank  Letter  of  Credit  No.     100"  


dated  July  1,  1921  to 

cover  shipment  of    Raw  Silk 

from  Yokohama 

Boston 
to 


224  FOREIGN  EXCHANGE 

in  such  manner  as  to  place  in  ihc  exporter's  hand  a  contract 
which  will  lund  the  Loudon  hank  to  accept  all  drafts  when 
properly  drawn,  thus  reducing  the  exporter's,  and  increasing 
the  bank's,  liability.  An  extra  commission  will  be  charged 
by  the  accepting  bank  when  a  letter  of  credit  is  confirmed,  and 
this  extra  charge  will  be  passed  on  to  the  client  of  the  Amer- 
ican bank  who  is  buying  the  letter.  A  specimen  of  a  typical 
letter  of  confirmation  is  given  below: 

BRITISH  FOREIGN  BANK,  LIMITED 

Irrevocable  Export  .  London,  July  11, 1921 

Credit  No Expiring  October  1, 1921 


Japanese  Exporters 
Yokohama,  Japan. . 

You  are  hereby  authorized  to  draw  up)on  us  for 
Accoimt  of  Mass,  Weaving  Company 


To  the  extent  of  not  exceeding  £20,000 

Covering  shipments  of  raw  silk 


Bills  of  lading  issued  by  forwarding  agents  will  not  be  accepted 
unless  specifically  authorized  herein,  and  any  modification  of  the 
terms  of  the  credit  must  be  in  writing  over  authorized  signature  of 
this  Bank. 

Drawings  must  clearly  specify  the  number  of  this  credit. 
Yours  truly, 
Manager  Foreign  Department. 

This  confirmation  is  an  irrevocable  contract  during  the  term 
of  life  stated  upon  it.  If  the  issue  of  the  letter  of  credit  is  in- 
tended to  be  revocable  at  the  option  of  the  American  bank, 
this  fact  will  be  disclosed  by  the  absence  of  the  word  "  Irrev- 
ocable" at  the  top  of  the  letter  and  the  inclusion  of  a  state- 
ment reserving  to  the  bank  the  right  to  recall  the  credit  upon 
due  notice  to  the  exporter.  Sometimes,  an  accepting  bank 
wishes  to  inform  the  beneficiary  of  a  letter  of  credit  that  the 
credit  has  been  established  with  its  permission  and  yet  to 


LETTERS  OF  CREDIT  225 

avoid  granting  a  contract  of  acceptance :  this  may  be  done  by- 
including  in  its  letter  to  the  exporter  some  such  words  as  the 
following,  "This  letter  is  for  your  guidance  in  preparing  the 
documents  and  conveys  no  engagement  on  the  part  of  this 
bank."  The  confirmed,  irrevocable  credit,  however,  is  the  rule 
in  international  commerce. 

(c)  Draunng  and  handling  bills  under  a  letter  of  credit.  We 
have  now  reached  the  third  phase  of  the  operations  involved 
in  the  use  of  a  letter  of  credit  issued  by  one  bank  upon  an- 
other; in  discussing  the  processes  involved  in  the  drawing  of 
bills  under  the  authority  of  the  letter,  we  shall  best  proceed 
by  means  of  an  illustration.  Assume,  then,  that  the  Japanese 
exporters  of  silk,  in  the  illustration  used  earlier  in  this  chapter, 
had  required  the  Massachusetts  Weaving  Company  to  estab- 
lish in  their  favor  a  confirmed  irrevocable  sterling  credit  for 
the  total  of  twenty  thousand  pounds.  The  company  will 
sign  a  contract  with  the  Boston  bank  for  the  purchase  of  such 
a  letter,  will  receive  the  letter  and  send  it  to  the  exporters  in 
Japan.  The  transactions  at  that  end  will  proceed  much  as 
before,  the  exporters  drawing  in  sterling  instead  of  in  dollars 
as  shipments  are  made.  The  letter  of  credit  will  be  shown  by 
them  to  their  bankers  as  evidence  of  their  right  to  draw  and 
this  evidence  will  be  sufficient,  in  case  the  drafts  are  in  the 
prescribed  form  and  accompanied  by  the  prescribed  docu- 
ments, to  command  a  ready  market  for  their  bills.  If  the 
total  credit  is  exhausted  at  one  drawing,  the  letter  of  credit 
will  be  taken  up  by  the  Japanese  bank  and  added  to  the  other 
documents;  if  not,  each  drawing  will  be  endorsed  upon  the 
reverse  side  of  the  letter  and  a  subtraction  made  so  as  to  set 
forth  clearly  the  amount  of  credit  remaining,  and  with  the 
last  drawing  the  letter  will  be  surrendered  and  attached  to  the 
draft. 

Like  all  long  bills,  these  must  be  sent  for  presentment  to  the 
drawee.  Accordingly,  the  Japanese  bank  will  mail  them  to 
its  London  correspondent  who  will  present  them  for  accept- 
ance to  the  London  bank  on  which  they  are  drawn.  This 
bank  will  first  examine  the  documents  to  see  that  they  are  in 
order,  and,  finding  them  so,  will  then  accept  the  drafts,  de- 


eeo  FOREIGN  EXCHANGE 

taclnng  nnd  retaining  the  documents  in  its  own  possession. 
The  acceptances  will  then  be  discounted  in  the  London  mar- 
ket (assuming,  of  course,  that  the  Japanese  bank  does  not 
choose  to  retain  them  for  investment)  after  which  the  Jap- 
anese bank  will  have  a  credit  of  something  less  than  twenty 
thousand  pounds  sterling  in  London  against  which  it  can 
draw  drafts  for  sale  in  Yokohama.  The  bill  of  lading  and 
other  documents  retained  by  the  accepting  bank  will  be  for- 
warded to  the  American  correspondent  (in  this  case  the  Bos- 
ton bank)  with  notice  of  the  charge  which  has  been  made 
against  the  acceptance  account.  They  should  reach  Boston, 
under  normal  conditions,  considerably  in  advance  of  the  silk 
which  has  been  proceeding  by  freight  from  Japan,  and  the 
Boston  bank  will  inform  the  Weaving  Company  of  their  ar- 
rival. \Yhen  the  silk  appears  in  the  harbor,  the  company 
will  reach  some  agreement  with  the  bank,  usually  through 
the  agency  of  the  trust  receipt,  by  means  of  which  it  may 
gain  possession  of  the  goods  and  proceed  to  dispose  of  them 
according  to  the  plans  of  its  business. 

In  the  meantime,  the  acceptances  will  lie  in  the  hands  of 
some  investor  in  the  London  market  until  maturity,  when 
they  will  be  presented  to  the  accepting  bank  for  redemption. 
It  will  be  recalled  that  the  redemption  of  these  bills  is  a  legal 
obligation  of  the  acceptor;  that  the  London  bank  has  bound 
its  Boston  correspondent  to  cover  this  obligation  by  the  re- 
mittance of  funds  before  the  acceptances  mature,  and  that 
the  Boston  bank  has  passed  this  obligation  on  to  its  client, 
the  Massachusetts  Weaving  Company.  To  place  the  ac- 
ceptor in  funds  for  redemption,  a  remittance  of  sterling  de- 
mand drafts  must  leave  Boston  seven  days  before  each  draft 
matures,  and  on  the  preceding  day,  or  eight  days  before  the 
term  of  the  draft,  the  Weaving  Company  will  be  bound  by  its 
contract  to  deliver  the  proper  amount  of  sterling  sight  bills, 
or  to  deposit  enough  money  with  the  Boston  bank  to  buy 
these  bills  at  the  ruling  rate  of  exchange.  Thus  the  import- 
ers of  the  silk  will  discharge  their  obligation  under  the  contract 
for  the  letter  of  credit,  in  time  for  the  Boston  bank  to  dis- 
charge its  obligation  under  the  acceptance  agreement,  in 


LETTERS  OF  CREDIT  227 

time  for  the  London  bank  to  meet  its  acceptances.  More 
simply  stated,  the  Weaving  Company  ^\^ll  pay  for  its  silk  by 
passing  the  purchase  price  through  a  Boston  bank  to  London 
where  it  is  used  to  cancel  drafts  drawn  by  the  exporters 
against  the  shipment.  When  we  bring  the  two  parts  of  the 
commercial  transaction  together,  we  see  that  the  Japanese 
exporters  are  paid  cash  on  delivery  from  London  through  a 
local  bank  in  Yokohama,  and  that  the  American  importers 
repay  this  advance  by  remittance  to  London  at  a  later  date. 

52.  Banking  relations  involved  in  letter  of  credit.  Though 
in  the  present  chapter  we  are  primarily  interested  in  the  com- 
mercial aspects  of  bills  of  exchange,  it  may  be  well  at  this 
point  to  review  briefly  the  banking  relations  created  by  the 
series  of  transactions  just  discussed.  There  are  three  banks 
concerned  in  these  transactions:  the  buying  bank  in  Yoko- 
hama, the  accepting  bank  in  London,  and  the  remitting  bank 
in  Boston.  The  first  and  third  deal  with  exporter  and  im- 
porter respectively,  while  the  second  acts  as  a  focal  point  for 
these  two.  Now,  the  salient  feature  of  this  operation  in  for- 
eign exchange  is  that  none  of  the  banks  concerned  is  required 
to  advance  funds  of  its  own  at  any  stage  of  the  process,  yet  the 
exporters  receive  the  money  for  their  silk  long  in  advance  of 
the  payment  by  the  importers.  In  fact  the  chief  commercial 
function  of  the  letter  of  credit  is  to  make  it  possible  for  buyers 
of  goods  to  postpone  payment  wdthout  at  the  same  time  de- 
manding that  the  sellers  wait  for  their  money  until  payment 
is  made,  and  this  function  was  admirably  discharged  in  the 
foregoing  illustration.  The  exporters  in  Japan  received  the 
value  of  their  silk  as  soon  as  it  was  on  board  the  steamer;  but 
the  importers  in  America  made  no  payment  until  some 
months  later.  Now,  there  is  no  magic  in  letters  of  credit; 
some  one  must  have  bridged  this  gap  between  the  receipt  of 
money  in  Japan  and  its  payment  in  America:  who  was  this 
person?  To  prepare  ourselves  for  the  answer  to  this  question, 
let  us  first  see  that  the  advance  was  not  made  by  any  of  the 
three  banks  concerned. 

At  first  thought  it  aj)pcars  that  the  l)urdcn  of  advancing 
the  money  fell  upon  the  Japanese  bank,  for  it  was  this  iusti- 


228  FOREIGN  EXCHANGE 

tut  ion  which  immediately  furnished  the  funds  to  the  ex- 
porters. Now,  it  is  true  that  the  Japanese  bank  could,  if  it 
so  desired,  carry  through  the  transaction  in  such  a  way  as  to 
bear  the  burden  of  the  advance,  but  it  is  in  no  wise  compelled 
to  do  this  and  only  in  very  rare  instances  will  it  choose  to  do 
it.  lu  our  illustration,  each  sterling  draft  bought  by  this 
bank  was  hurried  to  London  for  acceptance  through  a  corre- 
spondent in  that  city.  After  acceptance,  the  draft  was  sold 
in  the  discount  market  and  the  proceeds  carried  to  the  credit 
of  the  account  of  the  Japanese  bank,  thus  placing  it  in  po- 
sition to  sell  sterling  demand  drafts  in  Japan,  Every  sterling 
bill  bought  from  the  exporters  and  discounted  in  London 
would  be  tantamount  to  a  transfer  of  funds  from  the  bank's 
vaults  to  the  vaults  of  its  London  correspondent;  but,  on  the 
other  hand,  every  sterling  draft  sold  against  this  credit  would 
reverse  the  transfer  and  replace  the  funds  in  the  bank's 
vaults.  Now,  the  transaction  we  are  considering  can  cause 
an  advance  payment  by  the  Japanese  bank  only  if  its  re- 
ceipts from  the  sale  of  sterling  demand  drafts  lag  behind  its 
expenditure  in  the  purchase  of  sterling  commercial  bills 
drawn  under  the  letter  of  credit,  and  no  lag  need  occur.  The 
demand  drafts  may  be  sold  on  the  same  day  the  commercial 
bills  are  bought ;  both  will  consume  exactly  the  same  amount 
of  time  in  reaching  London,  and,  arriving  there  simul- 
taneously, ^nll  offset  each  other.  If  the  Japanese  bank  is 
regularly  engaged  in  foreign  exchange  dealings,  it  may  be  as- 
sumed as  a  fundamental  rule  that  every  purchase  of  sterling 
bills  is  counterbalanced  by  an  immediate  sale. 

In  one  case,  only,  will  the  burden  of  the  advance  fall  upon 
the  Japanese  banker,  namely,  if  he  choose  to  instruct  his 
London  correspondent  not  to  sell  the  acceptance  in  the  money 
market,  but  to  hold  it  to  maturity.  When  he  buys  the  ster- 
ling commercial  bill,  the  banker  in  Yokohama  will  discount 
the  face  amount  for  the  length  of  time  the  bill  is  to  run;  if, 
now,  the  bill  is  held  in  London  until  maturity,  and  then  pre- 
sented to  the  accepting  bank  for  redemption,  the  banker  who 
bought  it  will  get  back  more  money  than  it  cost  —  in  other 
words,  he  will  earn  interest  on  the  funds  invested  in  the  pur- 


LETTERS  OF  CREDIT  229 

chase  price.  But,  in  this  case,  he  will  also  be  estopped  from 
selling  sterling  demand  drafts  upon  the  day  he  buys  the  bill, 
for  he  will  have  no  funds  in  London  for  the  redemption  of  the 
demand  drafts  until  some  months  later.  He  is  forced  to  wait 
for  the  recovery  of  his  funds  and,  as  a  remuneration  for  this 
waiting,  receives  interest  earned  by  the  acceptance  while  it 
is  lying  in  the  hands  of  his  London  correspondent.  We  must 
emphasize  the  point,  however,  that  this  burden  of  waiting  is 
not  forced  upon  the  banker  as  an  essential  element  in  his 
transaction,  and  repeat  what  was  said  above,  that  as  a  rule, 
he  will  sell  sterling  demand  drafts  as  rapidly  as  he  buys  ster- 
ling commercial  bills,  and  thus  make  no  advance  of  money  at 
all.  Why,  then,  should  he  engage  in  foreign  exchange  trans- 
actions; do  not  his  operations  amount  to  taking  money  out  of 
one  pocket  and  replacing  it  in  another.?  He  engages  in  this 
business  to  win  a  frofit  and  not  to  earn  interest,  and  his  profit 
is  derived  from  selling  demand  drafts  at  a  higher  rate  than  he 
pays  for  commercial  bills.  Thus,  though  his  purchases  and 
sales  amount  to  taking  from  one  pocket  and  returning  to 
another,  he  is  constantly  putting  back  more  than  he  takes 
out  and  thus  has  sufficient  inducement  to  continue  in  business. 
Having  seen  that  the  Japanese  banker  does  not  advance  the 
money  paid  to  the  exporters  of  the  silk,  it  can  be  shown  in 
much  shorter  compass  that  neither  of  the  other  two  banks 
makes  this  advance.  The  accepting  bank  in  London  merely 
lends  its  name,  paying  out  no  money  until  the  maturity  of 
the  acceptances  and,  then,  merely  delivering  funds  placed  in 
its  hands  by  the  Boston  correspondent.  In  the  same  manner, 
it  is  apparent  that  the  Boston  bank  makes  no  advance  pay- 
ment, nor,  indeed,  any  payment  at  all  out  of  its  own  funds; 
for  the  importers  of  the  silk  will  have  discharged  their  obli- 
gation under  the  contract  for  the  i)urchase  of  the  letter  of 
credit  before  the  Boston  bank  is  called  upon  to  make  a  re- 
mittance to  London.  The  advance  is  measured  by  the 
length  of  time  which  elapses  between  the  receipt  by  the 
exporters  of  the  purchase  price  of  the  silk  and  the  payment  of 
this  price  by  the  importers.  This  interval  is  roughly  equal 
to  the  life  of  the  draft  which  is  used  to  finance  the  sale;  who- 


230  FOREIGN  EXCIIANGE 

ever  it  is  that  buys  this  draft  and  holds  it  to  maturity,  he  will 
be  the  real  financier  of  the  transaction,  in  the  sense  that  it  will 
be  he  who  parts  with  money  to  satisfy  the  sellers  and  agrees 
to  wait  for  the  recovery  of  this  money  until  the  buyers  make 
payment.  This  person  is  usually  some  one  in  the  discount 
market  of  London  who,  with  money  to  lend,  buys  the  ac- 
ceptance and  holds  it  to  maturity.  He  will  be  in  no  way  con- 
cerned with  the  purchase  and  sale  of  the  silk,  nor  with  any 
other  commercial  aspect  of  the  transaction;  for  he  will  buy 
the  acceptance  solely  on  the  strength  of  the  banker's  name 
which  it  bears.  A  true  money-lender,  he;  yet  without  his 
knowledge  the  funds  which  he  brings  to  the  discount  market 
of  London  will  prove  a  vital  agent  in  a  commercial  trans- 
action involving  markets  many  thousands  of  miles  removed 
from  his.  At  this  place  we  may  stress  the  point  that  it  has 
been  largely  due  to  the  presence  of  many  such  money-lenders 
in  the  London  market,  whose  presence  assures  the  buyers  of 
sterhng  long  bills  the  world  over  of  a  broad  and  stable  demand 
for  these  bills  after  acceptance,  that  the  sterling  letter  of 
credit  has  proved  so  well  adapted  to  the  uses  of  exporters  in 
the  world's  principal  markets. 

53.  Superiorities  of  the  commercial  letter  of  credit.  The 
perfection  of  the  letter  of  credit  as  a  device  for  financing  inter- 
national transactions  has  been  of  immense  service  to  the  busi- 
ness men  of  the  world  who  engage  in  foreign  trade.  From  the 
point  of  view  of  the  exporter,  a  confirmed  credit  offers  the 
following  advantages : 

(a)  As  has  been  stated  above,  it  gives  rise  to  a  bill  of  ex- 
change more  easily  sold  than  an  ordinary  trade  bill,  and 
one  which  commands  a  more  favorable  and  stable  rate 
of  exchange.  This  either  increases  the  exporter's  profit, 
or  enables  him  to  quote  a  lower  price  for  his  goods,  thus 
increasing  their  selling  power. 
(6)  By  virtue  of  the  salability  of  his  drafts,  the  letter  of 
credit  resolves  his  transaction  into  a  cash  sale,  and  this 
without  exacting  onerous  terms  from  his  foreign  cus- 
tomers. Freight  shipments  in  international  commerce 
are  time-consuming;  long  credit  terms  are  practically 


LETTERS  OF  CKEDIT  231 

unavoidable  if  goods  are  to  move  freely  from  seller  to 
buyer  between  markets  far  removed  from  each  other. 
The  letter  of  credit  enables  the  exporter  to  offer  such 
terms  to  those  of  his  customers  who  are  in  position  to 
provide  the  confirmed  credit,  without  himself  bearing 
the  credit  burden. 

(c)  Many  times  goods  must  be  made  especially  to  suit  the 
requirements  of  the  importer's  market.  This  often 
demands  of  the  exporter  the  institution  of  special 
processes  of  manufacture,  or  the  adaptation  of  his  plant 
to  cater  to  foreign  tastes;  and  even  if  this  is  not  true, 
the  filling  of  an  order  compels  the  exporter  to  set  aside 
labor  and  capital  and  to  incur  expenses  which  might  be 
devoted  to  other  ends.  When  the  process  of  making 
the  goods  must  be  begun  some  time  before  the  goods 
are  ready  to  ship,  exporters  will  very  naturally  be 
reluctant  to  incur  this  expense  unless  assured  that  the 
order  will  not  be  cancelled  at  some  time  prior  to  ship- 
ment. An  irrevocable  letter  of  credit  gives  them  this 
assurance,  for  such  a  credit  once  established  in  their 
favor  cannot  be  recalled  by  the  foreign  buyer  so  long  as 
the  exporter  can  show  the  documents  required  by  the 
letter.  The  perfection  of  commerce  between  nations 
depends  upon  the  development  of  such  confidence. 

(d)  When  an  exporter  draws  an  ordinary  commercial  long 
bill,  his  liability  as  drawer  does  not  end  until  payment 
has  been  made  at  maturity.  Though  the  transaction 
may  appear  to  be  a  sale  for  cash  when  the  bill  is  sold  at 
the  time  of  shipment,  it  is  in  reality  based,  in  part,  upon 
the  credit  of  the  exporter,  and  this  credit  element  will 
eventually  be  brought  home  sharply  to  any  merchant 
who  employs  such  bills  on  a  considerable  scale  by  loss 
through  dishonor  on  the  part  of  some  customer.  Even 
if  the  exporter's  experience  is  entirely  free  from  losses, 
however,  the  employment  of  the  commercial  bill  is  none 
the  less  a  strain  upon  his  credit;  for  the  number  of  these 
bills  which  he  can  negotiate  at  any  time  with  his 
banker  is  proportioned  to  his  capital  assets,  the  banker 


282  FOREIGN  EXCHANGE 

quite  naturally  requiring  that  his  contingent  lialiility 
be  supported  by  adequate  capital.  Thus,  whether  the 
exiiorter  succeeds  in  selling  his  trade  bills  outright,  or 
must  content  himself  with  depositing  them  for  col- 
lection (and  the  latter  is  usually  the  experience  of  ex- 
porters), his  foreign  business  will  drain  his  credit  and 
restrict  the  range  of  operations  he  can  carry  on  wnth  a 
given  capital.  The  bill  drawn  under  a  confirmed  credit 
differs  from  the  ordinary  documentary  bill  in  that, 
once  negotiated  with  a  banker,  the  responsibility  is 
shifted  immediately  upon  the  issuing  bank  and  the 
exporter's  liability  ceases. 
(e)  An  additional  advantage  of  the  letter  of  credit  from  the 
exporter's  standpoint  is  to  be  found  in  the  fact  that  it 
frees  him  from  all  risk  of  a  falling  market  and  possible 
repudiation  of  the  goods  by  his  foreign  customer.  If 
prices  in  the  importer's  country  have  slumped  between 
the  time  of  sale  and  the  time  of  delivery,  he  may  be 
tempted  to  refuse  acceptance  of  the  goods;  imder  such 
conditions,  if  the  sale  is  financed  by  a  documentary 
bill,  the  importer  will  also,  in  all  probability,  dishonor 
the  draft  drawn  against  the  shipment  which  he  has 
refused  to  accept.  Then  the  exporter  will  be  put  to  the 
trouble  and  expense  of  disposing  of  the  goods  as  best 
he  can  and  bringing  action  against  the  defaulting 
buyer.  However,  when  the  importer  supplies  the  ex- 
porter with  a  letter  of  credit,  one  of  the  terms  of  his 
agreement  with  the  bank  which  issues  the  letter  is  that 
repudiation  of  the  goods  will  in  no  wise  diminish  his 
obligation  to  make  good  all  drafts  drawn  imder  the 
letter.  No  disturbance  of  the  importer's  market,  nor 
even  insolvency  of  the  importer,  can  destroy  the  ex- 
porter's market  for  his  bills;  accordingly,  he  can  enter 
into  long-term  contracts  for  the  shipment  of  goods, 
free  from  all  risk  of  a  falling  market  or  of  repudiation 
by  the  buyer. 
The  advantages  of  the  confirmed  credit  to  the  importer  may, 
to  a  large  extent,  be  inferred  from  the  preceding  discussion. 


LETTERS  OF  CREDIT  233 

(a)  He  can  usually  obtain  better  terms  from  the  seller  than 
would  be  quoted  if  a  credit  were  not  established.     This 
price  concession  is  no  burden  on  the  exporter,  since  the 
sale  price  of  his  dri:fts  will  be  proportionately  large. 
(6)  He  can,  vrithout  difficulty,  induce  foreign  producers  to 
undertake  long-term  contracts  whose  performance  re- 
quires special  processes  of  manufacture,  or  large  initial 
outlays.     At  the  same  time,  he  can  control  the  per- 
formance of  the  contract  within  a  set  time  by  adjusting 
the  date  upon  which  the  credit  will  expire,  and  by 
requiring  certificates  of  inspection  among  the  docu- 
ments, thus  assuring  himself  that  the  goods  will  be 
shipped  as  they  are  needed,  and  will  be  up  to  standard, 
(c)  The  credit  can  be  varied  in  different  ways  to  conform 
to  his  business  needs.     The  term  of  the  drafts  can  be 
long  or  short  accordingly  as  his  projects  for  disposing 
of  the  importation  vary;  the  amount  of  the  drafts  may 
be  limited  to  a  proportion  of  the  invoice  price  as  a  pro- 
tection against  bad  faith  on  the  part  of  the  exporter. 
It  should  be  pointed  out,  however,  that  the  bank  which 
grants  the  letter  of  credit  waives  all  obligation  to  guarantee 
the  goods  either  as  to  quantity  or  quality,  and  that  the  im- 
porter agrees  to  this  condition.    Even  flagrant  violation  of  the 
contract  by  the  exporter  does  not  clear  the  importer  of  his 
duty  to  pay  the  amount  agreed  upon  in  his  contract  with  the 
bank,  so  long  as  the  bills  of  exchange  are  properly  drawn. 
Importers  have  occasionally  been   defrauded  in  the  most 
palpable  fashion  by  short  shipment,  or  shipment  of  bad 
quality,  and  have  discovered  to  their  surprise  and  grief  that 
proof  of  fraud  does  not  suffice  to  cancel  the  credit.    Bankers 
attempt  to  make  this  matter  clear  at  the  time  the  letter  of 
credit  is  issued,  but  do  not  always  succeed.     WTiat  appears 
an  injustice  to  the  importer,  who  is  compelled  to  pay  for  use- 
less goods,  is  from  the  point  of  view  of  the  lianks  the  only 
defensible  business  policy.     They  cannot  involve  themselves 
in  commercial  undertakings  to  the  extent  of  guaranteeing  the 
goods.     All  commercial  risks  nuast  be  borne  })y  the  i)arties 
to  the  commercial  transaction;  and,  when  a  letter  of  credit 


234  FOREIGN  EXCfLVNGE 

is  used  as  the  financing  instrument,  these  risks  are  taken  from 
the  exporter  and  i)laced  solely  on  the  importer.  The  latter 
\nust  not  only  bear  the  risk  of  bad  faith  on  the  part  of  his 
foreign  client,  but  also,  as  explained  above,  the  risk  of  a  falling 
market  and  a  losing  venture  within  his  own  business  area. 

54.  Travelers'  letters  of  credit.  The  letters  of  credit  thus 
far  described  were  used  to  finance  business  transactions  and 
were,  for  that  reason,  called  commercial  letters.  All  importa- 
tions of  goods  have  substantially  the  same  effect  upon  the 
exchange  market,  regardless  of  the  form  of  bill  of  exchange 
called  for  by  the  terms  of  sale;  this  effect  is  to  increase  the 
demand  for  foreign  bills  of  exchange  in  the  importing  market. 
When  a  letter  of  credit  is  used  as  the  financing  instrument, 
this  demand  for  bills  of  exchange  does  not  arise  at  the  time 
the  goods  enter  the  country,  nor  are  the  bills  demanded 
necessarily  drawm  upon  the  country  from  which  the  goods 
come;  but,  eventually,  the  importing  merchant  is  forced  to 
enter  the  market  as  a  buyer  of  some  kind  of  exchange  to  an 
amount  equal  to  the  value  of  his  importation.  The  same 
effect  upon  the  exchange  market  is  produced  by  non-com- 
mercial transactions  between  nations,  transactions  which 
usually  involve  the  supplying  of  services  by  one  country  to 
another.  Some  of  these  non-commercial  transactions  are 
also  commonly  financed  by  letters  of  credit;  this  is  especially 
true  of  the  services  rendered  American  travelers  by  foreign 
hotels,  theatres,  art  galleries,  etc.  The  traveler's  letter  of 
credit  has  come  into  favor  as  an  agent  for  financing  these  ex- 
penditures in  foreign  countries;  it  does  not  greatly  differ  from 
the  commercial  letter  which  we  have  been  discussing,  and  has 
the  same  ultimate  effect  of  increasing  the  demand  for  bills  of 
exchange  in  the  United  States. 

The  traveler's  letter  of  credit  may  take  either  of  the  two 
forms  in  which  commercial  letters  are  issued;  that  is  to  say, 
it  may  be  drawn  upon  the  issuing  bank  or  upon  another  bank, 
usually  located  in  a  different  country.  The  sterling  letter, 
however,  is  in  wide  use  among  American  tourists.  A  copy 
of  such  a  letter  appears  on  page  235.  The  traveler,  before 
leaving  the  country,  goes  to  his  banker  and  buys  a  letter 


LETTERS  OF  CREDIT  235 

Form  17.  Thavelek's  Sterling  Letter  of  Credit 
Guaranty  Trust  Company  op  New  York 
Circular  Letter  of  Credit 

No 

New  York, 


Gentlemen : 

We  beg  to  introduce  to  you  and  to  commend  to  your  courtesies, 

in  whose  favor 

we  have  opened  a  credit  of 

Pounds  Sterling,  and  whose  drafts  to  that  extent  at  sight  upon  the 

Guaranty  Trust  Company  op  New  York,  London 

we  engage  shall  meet  with  due  honor  of  negotiation  within 

months  from  this  date. 

The  amount  of  each  payment  must  be  endorsed  on  this  letter 
and  your  negotiation  of  the  drafts  will  be  considered  a  guarantee 
that  the  requisite  endorsements  have  been  made. 

You  will  please  observe  that  all  such  drafts  be  marked  as  "Drawn 
against  the  Guaranty  Trust  Company  of  New  York  Letter  of  Credit 
No " 

This  letter  must  be  attached  to  the  last  draft  drawn. . 

We  remain,  Dear  Sirs, 
Signature  of  Yours  faithfully. 


vice  president 
secretary 


To  Messieurs  Our  Correspondents. 


236  FOREIGN  EXCHANGE 

a(l(lrossed  to  nil  corrcspondciils  of  the  lyondon  bank  against 
vhic'h  the  letter  is  drawn,  requesting  these  correspondents  to 
honor  the  sterling  drafts  of  the  traveler  up  to  the  amount 
stated  ill  the  letter.  At  the  same  time,  the  London  hank  is 
told  that  the  credit  has  been  established  in  the  traveler's 
favor,  and  this  bank  is  prepared  to  charge  the  balance  of  the 
American  bank  with  the  drafts  as  rapidly  as  they  come  in. 
As  funds  are  needed  by  the  traveler,  the  letter  is  presented  to 
any  one  of  a  list  of  foreign  banks  whose  names  and  addresses 
are  printed  upon  its  face,  and  sterling  drafts  of  the  required 
size  are  drawn.  The  letter  serves  as  evidence  of  the  traveler's 
right  to  draw,  and,  as  a  check  against  forgery,  it  bears  a 
specimen  of  the  traveler's  signature.  These  drafts  are  all 
drawn  for  sight  payment  and  are  negotiated  at  the  sterling 
sight  rate  of  the  market  in  which  they  are  bought.  The 
amount  of  each  one  will  be  endorsed  upon  the  reverse  side 
of  the  letter  and  a  subtraction  will  be  made,  setting  forth  the 
extent  of  the  credit  remaining.  If  the  total  credit  is  ex- 
hausted, the  letter  will  be  taken  up  by  the  banker  who  buys 
the  final  drafts  and  sent  to  the  London  correspondent ;  if  it  is 
not  exhausted,  the  traveler  w'ill  receive  a  refund  from  the 
American  bank  equivalent  to  the  unused  portion  of  the  credit. 
When  selling  a  traveler's  letter  of  credit,  the  American 
bank  usually  demands  in  advance  a  price  in  dollars  equal  to 
the  total  credit  computed  at  the  ruling  sight  rate  for  sterling 
exchange  plus  any  commission  charge  which  it  may  choose  to 
make.  It  then  has  in  hand  funds  sufficient  to  buy  sight 
drafts  on  London  to  cover  the  total  charge  w'hich  can  be 
made  against  its  balance  in  that  city,  and  may  straightway 
strengthen  the  balance  by  sending  over  the  required  amount 
of  sterling  exchange.  On  the  other  hand,  it  may  choose  to 
make  the  remittance  later  as  the  traveler's  drafts  find  their 
way  into  the  hands  of  its  London  correspondent;  but  in  so 
doing,  it  will  obviously  run  the  risk  of  a  rising  rate  of  sterling 
exchange.  Whether  the  remittance  is  made  at  the  time  the 
letter  is  sold  or  at  a  later  date,  the  American  bank  will  be 
forced  into  the  exchange  market  of  this  country  as  a  buyer 
of  sterling  bills  with  w^hich  to  repair  its  London  balance;  thus 


LETTERS  OF  CREDIT  237 

the  purchase  of  foreign  services  by  American  travelers,  Hke 
all  other  importations,  has  the  final  effect  of  increasing  the 
demand  for  foreign  bills  of  exchange  in  our  market.  It  is  true 
that  the  effect  may  not  be  so  simple  and  direct  as  it  is  assumed 
to  be  in  the  foregoing  analysis.  Frequently,  American  banks 
buy  exporters'  bills  in  amounts  large  enough  to  create  for- 
eign balances  of  sufficient  size  to  meet  the  demand  of  our 
tourists  and  so  are  not  compelled  to  buy  additional  sterling 
exchange  each  time  travelers'  letters  of  credit  are  issued.  Yet 
the  effect  of  these  letters  upon  the  demand  for  sterling  is  vir- 
tually the  same ;  they  provide  the  bankers  with  opportunities 
to  utilize  their  London  credits  and  so  increase  their  power  to 
buy  sterling  commercial  bills  profitably. 

A  foreign  banker  who  buys  the  traveler's  sterling  draft  will 
view  it  simply  as  a  demand  bill  of  exchange  to  be  cashed  in 
London  by  his  correspondent  and  added  to  his  balance  in  that 
city.  It  will  be  his  intention  to  use  the  proceeds  as  cover  for 
drafts  which  he  has  drawn  or  will  draw  against  the  London 
correspondent,  and  will  therefore  base  his  buying  price  upon 
the  rate  at  which  he  can  sell  his  own  sterling  demand  drafts, 
allowing  a  sufficient  margin  to  afford  himself  a  profit.  The 
traveler  must  bear  the  risk  of  exchange,  since  the  price  he 
pays  for  his  right  to  draw  against  London  will  be  governed 
by  the  sight  rate  of  the  day  the  letter  of  credit  is  bought, 
while  the  amount  he  receives  for  his  drafts  will  conform  to  a 
different  rate  in  another  city  and  at  a  later  day.  The  risk 
may  work  either  to  his  profit  or  loss,  according  to  the  move- 
ment of  the  rate  of  exchange,  though  in  normal  times  the 
fluctuation  is  rarely  great  enough  to  have  a  material  effect 
upon  his  costs. 

In  recent  years,  and  especially  since  the  breakdown  of  the 
exchange  market  following  the  Great  War,  the  letter  of  credit 
issued  by  the  American  bank  against  itself  has  begun  to  dis- 
place the  more  complex  sterling  letter.  Obviously,  the  use- 
fulness of  the  credit  from  the  point  of  view  of  the  buyer  will 
be  tested  by  the  ease  with  which  he  can  dispose  of  the  drafts 
he  draws  under  its  authority.  Drafts  drawn  in  dollars  will 
serve  his  purpose  only  if  bankers  in  all  the  principal  foreign 


£38 


FOREIGN  EXCHANGE 


cities  are  prepared  at  all  times  to  buy  them,  and  this  is  rapidly 
coming  to  pass  with  the  spread  of  American  branch  banks 

abroad  and  the  increase 
Form  18.  T^^^'s  Chbck  in  -^  ^^e  demand  in  foreign 

centers  for  dollar  ex- 
change. The  sight  drafts 
drawn  against  a  traveler's 
dollar  letter  of  credit  may 
be  bought  by  foreign 
bankers  with  whom  the 
American  bank  carries  a 
balance;  when  this  is 
done,  the  face  of  the  draft 
is  charged  against  the 
balance  of  the  American 
bank  at  the  rate  of  ex- 
change used  by  the 
foreign  banker  when  the 
draft  was  bought.  Other 
bankers,  not  correspond- 
ents of  the  bank  which 
issues  the  letter,  will  ne- 
gotiate these  drafts  when 
confident  of  their  ability 
to  reimburse  themselves 
by  drawing  and  selling 
their  own  sight  drafts 
against  the  American 
bank. 

55.  Travelers'  checks. 
These  are  a  variation  of 
the  traveler's  letter  of 
credit  in  which  the  drafts 
are  drawn  in  dollars  for 
convenient  amounts  by 
the  issuing  bank  and  delivered  in  this  form  to  the 
traveler.  These  drafts  are  made  self-identifying  by  a 
simple  expedient;  the    purchaser  writes  his   signature   in 


LETTERS  OF  CREDIT  239 

the  upper  left-hand  corner  at  the  time  of  purchase,  but 
does  not  countersign  until  the  time  of  encashment  when 
a  second  signature  is  made  in  the  presence  of  the  person 
accepting  the  check.  Without  the  second  signature,  the 
checks  have  no  value;  with  it,  their  currency  in  foreign  coun- 
tries is  very  broad,  for  they  are  frequently  taken  as  cash  by 
the  hotels,  ticket-offices,  and  shops  in  the  principal  cities  of 
the  world.  In  case  a  check  is  lost,  notification  is  sent  to  the 
issuing  bank  which  stops  payment  at  all  its  foreign  branches 
and  refunds  the  purchase  price  under  guarantee  of  indemnity 
by  the  traveler  in  case  an  illegal  encashment  is  made.  Under 
normal  conditions,  it  was  the  practice  of  the  issuing  bank  to 
stamp  upon  the  face  of  these  checks  the  rate  of  exchange  at 
which  they  would  be  honored  by  foreign  correspondents,  thus 
freeing  the  traveler  from  all  risk  of  exchange;  but  with  the 
large  and  fluctuating  premium  on  dollar  exchange  now  (1921) 
obtaining  in  European  markets,  the  system  of  fixed  rates  has 
been  replaced  by  one  which  gives  the  American  traveler  the 
advantage  of  this  premium.  The  checks  are  now  drawn  pay- 
able in  foreign  currency  at  the  best  rate  ruling  for  exchange 
on  New  York  on  the  day  of  payment  and  are  charged  at  this 
buying  rate  against  the  foreign  balance  of  the  issuing  bank. 
A  copy  of  the  traveler's  check  is  given  on  the  opposite  page. 


CHAPTER  IX 

OTHER  FORMS  OF  BANK  CREDIT 

56.  Variations  of  the  bank  credit.  Bank  credits  are  sufl5- 
cicntly  elastic  to  permit  of  variation  to  meet  the  needs  of  in- 
dividual transactions  in  foreign  trade.  Although  the  forms 
of  letters  of  credit  discussed  in  the  preceding  chapter  are  the 
standards  in  the  financing  of  international  commerce,  neither 
procedure  nor  form  is  so  rigid  that  the  merchant  may  not, 
after  negotiation  with  his  banker,  fit  the  credit  to  the  pecu- 
liarities of  his  transaction  or  the  particular  requirements  of  his 
foreign  customer.  In  some  cases,  essentially  similar  to  those 
discussed,  the  letter  of  credit  is  omitted  from  the  transaction. 
The  importer  may  arrange  through  his  banker  to  place  a 
credit  at  the  disposal  of  the  exporter  in  the  exporter's  own 
market  and  simply  notify  him  of  the  creation  of  the  credit  at 
the  time  of  placing  the  order  for  the  goods. 

To  illustrate,  a  merchant  in  Buenos  Aires  ordering  goods 
from  a  commission  house  in  New  York  may  instruct  the  New 
York  firm  that  a  certain  bank  in  his  city  is  prepared  to  honor 
bills  drawn  against  the  shipment,  or  to  pay  cash  against  de- 
livery of  the  shipping  documents  without  the  formality  of 
drawing  the  bill  of  exchange.  To  place  this  credit  in  New 
York,  the  Argentine  merchant  must  act  through  his  own 
bank  in  Buenos  Aires  and  rely  upon  his  banker  to  create  the 
fund  available  for  the  use  of  the  exporter.  His  relations  with 
the  banker  in  Buenos  Aires  may  be  on  a  cash  basis;  that  is, 
he  may  merely  deposit  at  that  end  the  invoice  price  of  the 
goods,  or  its  equivalent  in  dollar  exchange,  and  instruct  his 
banker  to  place  the  deposit  in  New  York  to  the  credit  of  the 
commission  house  there.  Such  a  transaction,  however,  would 
involve  no  credit  element,  since  the  commercial  operation 
would  be  carried  through  upon  the  strength  of  the  importer's 
cash  resources.     It  would  become  a  credit  transaction  if  the 


OTHER  FORMS  OF  BANK  CREDIT  241 

importer  induced  his  banker  to  create  the  fund  in  New  York 
against  the  importer's  promise  to  repay  at  a  later  date. 
This  might  be  done  by  depositing  collateral  security  in  thje 
hands  of  the  banker,  or  by  giving  him  a  first  lien  on  the  goods 
about  to  be  imported,  or  in  other  ways  varying  according  to 
the  importer's  credit  rating  and  his  standing  with  the  bank. 
The  cost  of  the  credit  to  the  importer  would  include  the  in- 
terest charge  and  the  commission  of  the  banker.  From  the 
point  of  view  of  the  exporter,  the  sale  would  consist  simply 
of  a  dispatch  of  the  goods  and  the  collection  of  the  purchase 
price  from  a  local  bank. 

These  bank  credits,  which  omit  the  drawing  of  a  formal 
letter,  may  be  revolving,  or  self-continuing  credits.  This  is 
the  case  when  the  buyer  who  places  the  credit  at  the  disposal 
of  the  seller  forms  an  agreement  with  the  banks  involved 
whereby  the  credit,  when  once  used,  becomes  again  available 
without  the  formality  of  concluding  another  contract.  A 
revolving  credit  is  especially  serviceable  when  the  trans- 
actions between  buyer  and  seller  are  continuous  and  pro- 
tracted, since  it  obviates  the  delay  and  expense  of  corre- 
spondence, or  an  exchange  of  cables,  for  the  purpose  of  arrang- 
ing the  financing  details  of  each  particular  transaction.  To 
illustrate,  the  Argentine  importer,  who  figured  in  the  pre- 
ceding illustration,  places  in  New  York  for  the  benefit  of  the 
American  shipper,  a  credit  with  a  maximum  limit  —  say, 
ten  thousand  dollars  —  with  the  understanding  that,  as  each 
draft  is  honored  in  Buenos  Aires,  the  credit  is  replenished  by 
its  amount.  The  American  exporter  makes  an  initial  ship- 
ment, let  us  say,  of  one  thousand  dollars  value,  and  draws 
for  that  amount.  This  reduces  the  remaining  credit  to  nine 
thousand  dollars,  until  the  draft  is  liquidated  by  the  Argen- 
tine importer;  a  series  of  such  drafts  will  continue  to  deplete 
the  credit,  but  as  the  drafts  mature  and  are  paid  a  succession 
of  liquidations  replenishes  the  credit  and  permits  continued 
drawing  by  the  exporter.  If  the  total  amount  of  the  credit  is 
exhausted  at  any  time,  drawing  must  cease  until  some  of  the 
outstanding  drafts  have  been  honored. 

This  is  but  one  of  many  possible  forms  which  the  revolving 


24'2  FOREIGN  EXCHANGE 

credit  may  take.  Sometimes  the  agreement  calls  for  the 
drawing  of  a  specified  sum  in  a  single  draft,  upon  the  matur- 
ity anil  redemption  of  which  another  draft  for  the  same 
amount  may  he  drawn.  Again,  the  agreement  may  prescribe 
the  drawing  of  a  single  draft,  but  permit  a  second  drawing 
for  the  same  amount  without  awaiting  the  redemption  of  the 
first,  and  so  on  indefinitely.  Revolving  credits  usually  carry 
a  time  limit  beyond  which  they  do  not  run.  At  the  first  dis- 
honor by  the  drawee,  the  credit  agreement  is  abrogated  and 
all  drafts  outstanding  become  due  and  payable.  The  com- 
mission charges  are  based,  not  upon  the  maximum  amount 
of  the  credit  authorized,  but  upon  the  amounts  actually 
utilized  by  the  drafts  of  the  exporter. 

Bank  credits,  of  the  kinds  just  described,  may  be  confirmed 
or  unconfirmed.  In  the  preceding  illustrations,  it  was  as- 
sumed that  confirmation  of  the  credit  was  not  made  by  the 
New  York  bank;  that  is,  the  New  York  bank  did  not  issue 
to  the  exporter  anything  approaching  in  nature  the  letter  of 
credit  w'hich  would  give  the  exporter  a  legal  rifht  to  demand 
the  purchase  of  his  drafts  by  the  bank.  W  hen  confirmation 
does  not  take  place  —  and  the  New  York  bank  will  not  con- 
firm the  credit  unless  specifically  instructed  to  do  so  —  the 
exporter  will  merely  be  informed  by  his  foreign  customer  of 
the  creation  of  the  credit,  and  must  take  it  upon  himself  to 
verify  the  matter  by  inquiry  at  the  bank.  If  confirmation 
is  to  be  made,  it  must  be  demanded  at  the  time  the  terms  of 
sale  are  drawn  up  between  the  two  merchants.  The  act  of 
confirmation  increases  the  obligations  of  the  New  York  bank; 
until  this  bank  has  confirmed  the  credit,  its  obligation  to 
honor  the  exporter's  bills  lies  between  itself  and  the  bank  in 
Buenos  Aires  at  whose  request  the  credit  is  established;  by 
confirming  the  credit,  however,  the  New  York  bank  places 
in  the  exporter's  hands  a  document  by  which  it  is  bound  to 
honor  the  latter 's  drafts,  if  correctly  drawn,  regardless  of  any 
failure  on  the  part  of  the  Argentine  bank.  For  this  addi- 
tional obligation,  the  New  York  bank  will  demand  an  addi- 
tional commission,  w^hich  will  be  payable  by  the  Argentine 
importer  who  takes  the  initiative  in  establishing  the  credit. 


OTHER  FORMS  OF  BANK  CREDIT      243 

Form  19.  Letter  confirming  an  Irrevocable  Credit 

First  Commercial  Bank  op  New  York 

New  York        July  1,  1921 

Export  Credit  No.  100 

To        American  Exporter 

New  York  City 

Dear  Sirs : 
In  accordance  with  mail  instructions  from  Argentine 


Bank  we  open  an  irrevocable  credit  in  your  favor  for  the 

account  of  Argentine  Importer,  Buenos  Aires. 

Amount  $100,000.   One  hundred  thousand  dollars. 

Covering  shipment  of  electrical  machinery 

Drafts  under  this  Letter  of  Credit  are  to  be  drawn  at sight 

on  us  and  are  to  be  accompanied  by  a 

set  of  shipping  documents  consisting  of: 

Shipper's  invoices 

Consular  invoices,  if  required. 

Marine  insiu-ance  policies 

Full  set  of  ocean  steamer  Bills  of  Lading  made  out 


to  order  and  endorsed  in  blank 


It  must  be  understood  that  payments  under  this  credit  will  only  be  made 
provided  goods  are  actually  on  board  or  loading  on  the  vessel  named  in  the 
Bills  of  Lading. 

Marine  insurance  should  cover  from  Warehouse  to  Warehouse,  and  not 
less  than  ten  days  after  arrival,  and  also  include  deviation  clause,  craft 
and  lighter  clause,  negligence  and/or  latent  defect  clause.  Policies  reading 
free  from  particular  average  completely  must  not  be  tendered  without  prior 
arrangement  with  us. 

The  documents  should  be  presented  whenever  possible  in  time  to  be  for- 
warded on  the  steamer  carrying  the  goods. 

This  Letter  of  Credit  expires  on  Oct.  1,  1921 

If  you  are  unal)le  to  comply  with  the  terms  as  indicated  above,  please 
communicate  with  us  promptly  and  oblige. 

First  Commercial  Bank 


244  FOREIGN  EXCHANGE 

In  the  same  manner,  the  matter  of  the  revocation  of  the  credit 
must  be  settled  l)y  ajxreement  between  the  two  merchants. 

The  final  arrangement  regarding  these  matters  of  revoca- 
tion and  confirmation  of  the  credit  will  reflect  the  bargaining 
power  of  buyer  and  seller  in  international  trade.  It  is  natural 
for  the  seller  to  desire  a  confirmed,  irrevocable  credit.  Its 
possession  enables  him  to  go  about  the  business  of  filling  the 
imi)orter's  order  with  confidence,  even  if  this  involves  incur- 
ring costs  and  forming  obligations  to  purchase  goods  or  raw 
materials  in  advance  of  the  importer's  payment ;  for  the  con- 
firmation of  the  credit  by  the  American  bank  will  assure  the 
exporter  a  market  for  his  bills,  as  long  as  they  are  drawn  in 
proper  order,  even  if  the  foreign  buyer  should  suffer  business 
failure  or  repudiate  his  contracts.  In  other  words,  the  letter 
of  confirmation  reduces  the  exporter's  risk  to  that  of  failure 
by  the  American  bank  which  has  undertaken  to  honor  his 
draft.  On  the  other  hand,  it  is  equally  natural  for  the  im- 
porter to  attempt  to  reduce  his  financing  costs  to  the  mini- 
mum. To  obtain  a  confirmed,  irrevocable  credit  will  not 
only  add  to  the  commission  which  he  must  pay,  but  will  re- 
quire the  pledge  of  collateral  and  the  fulfillment  of  other 
conditions  laid  down  by  his  banker.  A  copy  of  the  form  used 
by  an  American  bank  to  confirm  an  irrevocable  credit  is  given 
on  page  243;  by  the  substitution  of  the  word  "revocable" 
for  "irrevocable,"  this  same  letter  serves  to  confirm  a  credit 
which  may  be  revoked  at  the  option  of  importer,  or  either  of 
the  banks.  Examination  of  this  letter  shows  that  it  very 
closely  resembles  a  letter  of  credit  issued  by  the  bank  upon 
itself. 

57.  Acceptance  credits  established  by  the  exporter.  Let- 
ters of  credit  and  other  bank  credits  used  for  financing  for- 
eign commerce  are  usually  established  at  the  initiative  of  the 
importer  in  favor  of  the  exporter.  This  is  the  normal  pro- 
cedure and  will  probably  prevail  again  when  credit  conditions 
of  the  world  have  been  reestablished  on  a  sound  basis.  In 
some  cases,  how^ever,  it  best  serves  the  interests  of  the  two 
merchants  for  the  exporter  to  arrange  with  his  own  banker 
the  creation  of  a  credit  which  will  place  the  banker's  accept- 


OTHER  FORMS  OF  BANK  CREDIT  245 

ance  at  his  disposal.  This  method,  which  was  denied  Amer- 
ican exporters,  prior  to  the  passage  of  the  Federal  Reserve 
Act  in  1913,  because  of  the  illegality  of  bankers'  acceptances 
and  the  absence  of  a  discount  market  in  New  York,  has  since 
that  date  been  increasing  in  importance,  owing  to  changes  in 
our  banking  mechanism  and  the  increasing  difficulty  of  fi- 
nancing our  export  trade  through  foreign  centers.  In  London, 
the  practice  is  of  long  standing.  The  procedure  when  the 
exporter  takes  the  initiative  in  establishing  the  credit  is  as 
follows:  The  exporter,  who  has  received  an  order  which  he 
needs  aid  in  financing  makes  an  arrangement  with  his  banker 
by  which  the  latter  agrees  to  accept  his  drafts  for  the  value  of 
the  goods.  The  exporter  draws  upon  his  foreign  customer, 
as  usual,  attaches  the  shipping  documents  to  his  bill  and 
delivers  the  bill  to  his  banker  as  collateral  security;  he  then 
draws  another  draft  upon  the  banker  for  the  same  amount  as 
his  foreign  bill  (or  a  portion  of  this  amount),  usually  making 
the  term  of  life  of  his  second  draft  such  that  it  will  not  mature 
until  after  the  foreign  bill  has  been  paid.  The  banker  ac- 
cepts the  draft  drawn  upon  him,  and  returns  it  to  the  ex- 
porter who  offers  it  for  sale  in  the  open  market,  thus  receiv- 
ing payment  for  his  goods.  By  the  terms  of  his  agreement 
with  his  banker,  the  exporter  is  bound  to  deposit  funds 
for  the  redemption  of  the  banker's  acceptances  before  their 
maturity. 

A  copy  of  the  acceptance  agreement  formed  between  the 
exporter  and  his  banker  is  given  on  pages  246-47.  It  will  be 
seen,  by  examining  its  terms,  that  the  agreement  contains  the 
provisions  of  a  letter  of  hypothecation,  together  with  some  of 
the  essentials  of  a  contract  for  the  purchase  of  a  letter  of 
credit.*  Thus,  as  in  the  letter  of  hypothecation,  the  exporter 
formally  transfers  to  the  banker  ownership  in  the  foreign  bill, 
the  goods  and  the  shipping  documents  which  represent  them, 
giving  the  banker  power  to  seize  and  sell  the  goods  if  such 
action  is  necessary  for  his  i)rotection.  This  })ledge  of  col- 
lateral docs  not,  however,  release  the  exporter  from  his  lia- 
bility as  drawer  to  indemnify  the  banker  from  any  loss  sus- 
'  For  description  of  these  documents  sec  pages  108  and  218. 


246  FOREIGN  EXCHANGE 

Form  20.    Acceptance  Agreement 

In  consideration  of  the  acceptance  by  The  First  Commercial  Bank  of 

my/our  draft  on  it  numbered dated 

payable for dollars 

and  all  other  drafts  which  may  hereafter  be  accepted  by  tlie  First  Commer- 
cial Bank  at  my/our  request,  I/we  hereby  deposit  with  and  assign  and 
transfer  to  said  First  Commercial  Bank  as  collateral  security  for  the  pay- 
ment of  said  drafts  at  maturity,  as  well  as  for  the  payment  of  any  and  every 
indebtedness  from  the  undersigned  to  the  First  Commercial  Bank. 


with  such  additional  collateral  as  may  from  time  to  time  be  required  by  the 
Bank,  and  which  the  undersigned  hereby  promises  to  furnish  on  demand. 
And  the  undersigned  hereby  gives  to  the  Bank,  or  its  assigns,  full  power  to 
sell,  assign  and  deliver  the  whole  or  any  part  of  said  collaterals,  or  any  substi- 
tutes therefor,  or  any  additions  thereto,  at  any  Brokers'  Exchange  or  else- 
where at  public  or  private  sale,  at  the  option  of  such  holder,  on  the  non- 
performance of  any  of  the  promises  herein  contained  and  without  notice  of 
amount  due  or  claimed  to  be  due,  without  demand  of  payment,  without  ad- 
vertisement and  without  notice  of  the  time  or  place  of  sale,  each  and  every  of 
which  is  hereby  expressly  waived;  and  on  any  such  sale  the  Bank,  its  assigns 
of  any  of  its  oflScers,  may  purchase  for  its  own  account  and  without  further 
accountability  except  for  the  purchase  price  thereof,  the  whole  or  any  part  of 
the  property  sold  from  any  right  of  redemption  on  the  part  of  the  under- 
signed, which  right  is  hereby  waived  and  released. 

It  is  further  agreed  that  any  surplus  arising  from  the  sale  of  said  collateral, 
beyond  the  amount  due  hereon,  shall  be  applicable  upon  any  claim  of  the  said 
Bank  arising  directly  or  by  assignment  against  the  undersigned  at  the  time 
of  said  sale,  whether  the  same  be  then  due  or  not  due. 

And  it  is  further  agreed  that  any  moneys  or  properties,  at  any  time,  in  the 
possession  of  the  First  Commercial  Bank  belonging  to  any  of  the  parties 
liable  hereon  to  said  Bank,  and  any  deposits,  balance  of  deposits  or  other  sum 
at  any  time  credited  by  or  due  from  said  Bank  to  any  of  said  parties  shall  at 
all  times  be  held  and  treated  as  collateral  security  for  the  payment  of  any 
other  obligation,  liability  or  indebtedness  of  the  undersigned  to  the  said 
Bank,  whether  due  or  not  due. 

And  I/we  also  agree  to  place  said  Bank  in  possession  of  suflScient  funds  in 
cash  previous  to  the  maturity  of  said  draft,  and  of  any  other  drafts  which  the 
said  Bank  may  hereafter  from  time  to  time  accept  to  meet  the  maturity  of 
said  drafts,  together  with  commission  as  agreed  and  interest  thereon,  cal- 
culated at  the  rate  of  six  per  cent  per  annum. 

Any  and  all  drafts  or  bills  of  exchange  now  or  hereafter  delivered  by  me/u3 
to  said  Bank  to  be  collected  shall  be  delivered  to  and  received  by  it  as  se- 
curity for  said  acceptance  or  acceptances  without  impairing  in  any  way 
my/our  obligations  hereunder  to  place  said  Bank  in  funds  before  the  maturity 
of  said  acceptance  or  acceptances  as  aforesaid,  and  all  documents  relating  to 


OTHER  FORMS  OF  BANK  CREDIT      247 

such  bills  for  collection  shall  likewise  be  held  and  received  by  said  Bank  as 
security  with  the  privilege  of  delivering  the  same  to  drawees  upon  acceptance 
or  payment  unless  instructions  to  the  contrary  shall  be  attached  to  each  bill. 

The  said  Bank  shall  have  the  right  to  apply  the  proceeds  of  such  collections 
against  the  payment  of  said  acceptance  or  acceptances  and  of  any  other  in- 
debtedness due  or  to  become  due  from  me/ us. 

It  is  expressly  agreed  that  I/we  assume  all  responsibility  for  the  collection 
of  drafts  or  bills  delivered  as  aforesaid  and  for  any  loss,  costs  or  expenses 
suffered  or  incurred  by  said  Bank  in  connection  therewith,  and  that  said 
Bank  shall  be  held  free  from  responsibility  for,  and  my/ our  obligation  to 
place  said  Bank  in  funds  as  aforesaid  shall  not  be  affected  or  impaired  by,  any 
default,  neglect,  suspension,  insolvency  or  bankruptcy  of  any  correspondeut 
or  sub-agent  to  whom  said  bills  or  drafts  may  be  entrusted  for  collection,  or 
for  any  delay  in  remittance,  loss  in  exchange,  or  the  loss  of  the  said  drafts  or 
bills  or  their  proceeds  during  transmission,  or  in  the  course  of  their  collection, 
and  I/we  expressly  agree  to  assume  all  responsibility  for,  and  that  my/our 
obligation  to  said  Bank  shall  not  be  affected  or  impaired  by,  the  non-pay- 
ment of  any  bills  of  exchange  which  may  be  received  by  said  Bank,  or  by  any 
collecting  bank,  agent  or  sub-agent  in  payment  of  such  drafts  or  bills  of 
exchange. 

I/we  also  assume  all  responsibility  for,  and  said  obligation  to  place  the 
Bank  in  funds  shall  not  be  affected  or  impaired  by,  any  risk  or  error  in  the 
course  of  transmission  of  telegrams  and  cablegrams  or  the  loss  of  letters  or 
other  documents  which  may  be  sent  in  connection  with  the  said  drafts  or 
bills  for  collection. 

I/we  also  agree  that  in  the  event  that  any  of  the  said  Bank's  correspond- 
ents, agents  or  sub-agent  for  collection  of  said  drafts  or  bills  shall  advise  it 
that  any  of  said  drafts  or  bills  are  not  promptly  accepted  or  paid,  or  in  the 
event  of  the  suspension,  failure  or  assignment  for  the  benefit  of  creditors,  or 
by  the  filing  of  a  petition  in  bankruptcy  against  the  drawee  or  the  drawees  of 
any  of  said  bills  or  drafts  for  collection,  that  I/we  will  immediately  upon  re- 
ceipt of  such  notice,  waiving  protest,  and  notice  of  protest,  pay  or  cause  to  be 
paid  to  said  Bank  in  cash  the  face  amount  of  any  such  draft  or  bill  for  collec- 
tion which  has  not  been  accepted  or  the  drawee  of  which  has  suspended, 
failed  or  assigned  or  against  whom  a  petition  in  bankruptcy  has  been  filed  as 
aforesaid. 

In  the  event  of  my/our  suspension,  failure  or  assignment  for  the  benefit  of 
creditors,  or  of  a  petition  in  bankruptcy  being  filed  against  mc/us,  or  the 
non-fulfillment  of  any  obligation  hereunder  on  my/our  part  shall  immedi- 
ately, without  notice,  become  due  and  payable,  and  it  is  also  agreed  in  either 
of  those  events,  said  Bank  may  take  such  action  with  respect  to  the  collection 
of  any  and  all  of  said  drafts  and  bills  delivered  as  aforesaid  for  collection,  as  it 
may  deem  advisable  to  protect  its  interests,  and  I/we  hereby  agree  to  in- 
demnify and  the  said  Bank  harmless  from  any  loss,  costs,  damage,  expense 
(including  reasonable  attorneys'  fees)  suffered  or  incurred  by  it  by  reason  of 
such  action  or  by  reason  of  my/our  failure  to  perform  any  of  the  obligations 
arising  hereunder. 

This  obligation  shall  continue  in  force  notwithstanding  any  change  in  the 
individuals  comprising  our  firm,  whether  such  change  shall  arise  from  the 
accession  of  one  or  more  new  partners  or  from  the  death,  retirement  or  se- 
cession of  any  partner  or  partners. 


£48  FOREIGN  EXCHANGE 

taincd  in  negotiating  the  foreign  bill.  As  in  the  contract  for 
a  letter  of  credit,  the  exporter  binds  himself  to  supi)ly  the 
funds  required  to  redeem  the  banker's  acceptances,  regardless 
of  the  conduct  of  his  foreign  client.  This  method  of  financing 
foreign  trade,  it  is  obvious,  rests  primarily  upon  the  standing 
of  the  shipper  with  his  own  banker;  as  a  result  of  the  agree- 
ment, the  bills  which  appear  on  the  New  York  market  are 
domestic  bills,  not  differing  greatly  from  similar  instruments 
arising  from  the  internal  trade  of  the  nation.  The  exporter's 
terms  with  his  foreign  customer  are  not  directly  involved  in 
this  type  of  credit;  but  the  possibility  of  availing  himself  of 
the  banker's  acceptance  enables  the  exporter  to  afford  more 
liberal  credit  terms  to  the  buyer,  and  thus  indirectly  deter- 
mines the  type  of  foreign  bills  of  exchange  which  arises  from 
the  transaction  between  them. 

58.  The  authority  to  purchase.  There  are  times,  when  the 
terms  of  sale  empower  the  seller  to  draw  an  ordinary  trade 
bill  upon  the  buyer,  that  the  merchants  seek  to  obtain  from 
the  banks  assurance  that  the  trade  bill  will  be  negotiable  in 
the  exporter's  market.  In  the  ordinary  run  of  international 
trade,  as  has  been  said,  the  trade  bill  is  not  a  readily  nego- 
tiable instrument;  often  the  bankers  will  handle  it  for  col- 
lection only,  thus  throwing  upon  the  exporter  the  burden 
of  a  period  of  waiting  for  his  receipts,  or  compelling  him  to 
resort  to  borrowing  a  portion  of  the  value  of  his  shipment 
from  the  banks  at  interest.  Such  terms  are  not  particularly 
favorable  to  the  exporter;  they  can  be  much  improved  if  the 
buyer  will  place  in  the  hands  of  the  exporter  assurance  that 
the  bill  will  be  bought  by  a  banker  as  soon  as  it  is  drawTi.  The 
document  which  embodies  this  assurance  is  called  an  au- 
thority to  purchase. 

The  procedure  by  which  the  authority  to  purchase  is  ob- 
tained and  used  is  somewhat  as  follows:  An  American  im- 
porter (let  us  say)  gives  his  banker  a  guaranty  that  he  will 
accept  and  pay  the  bills  to  be  drawn  by  an  exporter  in  Manila; 
the  American  bank  will  then  authorize  its  correspondent  in 
Manila  to  buy  the  bills  out  of  funds  kept  on  deposit  there; 
finally,  the  correspondent  will  inform  the  exporter  of  its  will- 


OTHER  FORMS  OF  BANK  CREDIT  249 

ingness  to  buy.  This  process  may  be  conveniently  divided 
into  three  phases: 

(a)  The  relations  of  the  importer  to  his  bank  in  America. 

(6)  The  relations  between  the  two  correspondent  banks. 

(c)  The  relations  between  the  foreign  correspondent  and 
the  exporter.     We  shall  examine  each  of  these  in  turn. 

(a)  The  ease  with  which  an  importer  obtains  from  his  bank 
an  authority  to  purchase  depends,  of  course,  upon  his  standing 
in  the  estimation  of  the  bank.  His  request  amounts  to  asking 
the  bank  to  invest  a  sum  of  money  upon  the  strength  of  his 
promise  to  make  restitution  at  a  later  date;  this  the  bank 
cannot  do  without  considerable  risk,  for  not  only  must  it  rely 
upon  the  good  faith  of  the  importer  to  accept  and  pay  the 
drafts  which  figure  in  the  transaction,  but  it  must  also  bear 
the  risk  of  business  failure  by  the  importer  during  the  interval 
which  elapses  between  the  purchase  of  the  bill  by  the  foreign 
correspondent  and  its  final  redemption.  The  slightest  fear 
that  the  business  of  the  importer  is  in  an  unstable  condition, 
that  the  man  himself  is  not  worthy  of  absolute  trust,  or  that 
the  particular  transaction  does  not  hold  forth  promise  of 
profit,  will  be  sufiicient  grounds  for  a  refusal  by  the  bank  to 
engage  in  the  undertaking.  If,  however,  the  bank,  satisfied 
on  these  points,  decides  to  conduct  the  transaction  for  the 
importer,  it  will  require  him  to  sign  a  document,  called  a 
letter  of  guarantee,  which  lays  down  the  conditions  under 
which  the  authority  to  purchase  is  granted.  The  following 
specimen  will  illustrate  the  essential  features  of  the  letter: 

Letter  of  Guarantee  No.  1000 

New  York,  July  18,  1921. 
To  the  New  York  Rank 

1.  In  consideration  of  your  bank  at  Manila  negoti- 

ating the  D/P  draft  or  drafts,  at  60         daj's'  sight,  drawn  and 

endorsed  by  Philippine  Export  Company  onus 

for  any  sum  not  exceeding  $1,000  we  hereby 

agree  duly  to  accept  the  same  on  presentation,  and  pay  the  amount 


250  FOREIGN  EXCHANGE 

thereof  nt  maturity,  provided  sueh  draft  or  drafts  shall  be  nego- 
tiated wiLliiu  G  months  from  this  date. 

With  interest  at  six  per  cent  from  date  of  draft  to  date  of  payment 
by  us. 

2.  At  the  time  of  negotiating  the  above  draft,  the  shippers  will 
hand  over  to  your  bank,  in  hypothecation,  as  collateral  security  to 
you  for  the  acceptance  and  payment  thereof,  invoice,  certificate  of 
origin,  bills  of  lading  and  policy  of  marine  insurance  for  the  merchan- 
dise, and  we  agree  that  in  case  of  need  you  shall  be  at  liberty  to  sell 
the  said  merchandise  and  apply  the  net  proceeds  toward  a  payment 
of  said  draft  without  prejudice  of  your  recourse  to  us  thereon  and 
all  other  parties  for  any  deficit.  The  word  "proceeds"  to  be  un- 
derstood to  include  the  amount  recoverable  under  any  insurance 
policies  covering  said  merchandise. 

3.  It  is  further  agreed  that  you  are  not  to  be  responsible  for  any 
loss  or  damage  that  may  happen  to  said  merchandise,  either  during 
its  transit  by  land  or  sea,  or  after  its  arrival,  or  by  reason  of  non-in- 
surance thereof,  not  for  any  deficiency  in  the  quality  or  value,  nor 
for  any  stoppage  or  detention  thereof  by  the  shipper,  or  by  any  other 
person  whatsoever.  And  inasmuch  as  the  above  stipulation  for 
handing  you  the  bills  of  lading  is  intended  for  your  security,  we  agree 
to  be  liable  as  aforesaid  on  the  negotiation  of  such  drafts  whether  the 
bills  of  lading  be  or  be  not  sufficient  to  cover  any  advance  made  by 
you  in  negotiating  the  drafts;  and  further  in  case  of  our  acceptance 
of  such  drafts  conditionally  or  your  handing  over  the  aforesaid 
documents  to  us,  we  undertake  to  pay  the  said  drafts  at  maturity, 
on  performance  of  such  conditions,  and  we  authorize  you  to  make 
such  agreements  as  you  think  proper  with  the  aforesaid  drawers 
and  indorsers,  touching  the  disposition  of  such  bills  of  lading  or  the 
proceeds  thereof,  or  any  goods  consigned  thereby. 

(Signed)        American  Importing  Company 

In  signing  this  document,  the  importer  accedes  to  three 
important  conditions : 

(1)  In  the  first  paragraph  he  binds  himself  to  accept  and 
redeem  the  drafts  drawn  by  the  foreign  shipper  if  they 
conform  to  certain  prescriptions  as  to  amount  and 
usance,  and  are  draw^n  within  a  hmited  period  of  time. 
This  is  a  contract  w'hich  the  banker  can  enforce  at  law, 
or  upon  the  strength  of  which  he  can  recover  damages 
due  to  default  of  the  importer. 


OTHER  FORMS  OF  BANK  CREDIT  251 

(2)  In  the  second  paragraph,  an  agreement  is  made  that 
the  goods,  represented  by  the  bills  of  lading,  will  be 
delivered  to  the  banker  as  collateral  security.  Formal 
hypothecation  of  this  collateral  must  be  made  by  the 
exporter,  and  the  banker  is  empowered  to  dispose  of  the 
goods,  using  the  proceeds  to  reimburse  himself  for  any 
outlay  in  connection  with  the  transaction,  in  case  of 
need.  Attention  is  called  to  the  fact  that  the  importer 
expressly  agrees  that  the  depositing  of  this  collateral 
is  not  to  be  considered  a  waiver  of  the  banker's  right  of 
recourse  against  him  and  all  other  parties  to  the  bill. 
The  liability  of  the  importer  after  acceptance  of  the 
bill  is  not  to  be  reduced  by  any  action  which  the 
banker  may  choose  to  take  concerning  the  shipment. 

(3)  In  the  third  paragraph,  the  banker  is  absolved  from 
any  obligation  to  guarantee  the  goods,  or  even  the  ship- 
ment of  the  goods  by  the  exporter.  This  provision, 
when  taken  in  conjunction  with  paragraph  1,  has  the 
effect  of  binding  the  importer  to  accept  the  drafts 
whether  or  not  the  goods  are  shipped  and  regardless 
of  the  condition  in  which  they  reach  him. 

Thus  the  effect  of  the  letter  of  guarantee  is  to  free  the 
banker's  claim  against  the  importer  from  any  limiting  con- 
ditions relative  to  the  particular  importation  and  to  base  it 
upon  the  importer's  credit  in  its  entirety,  but  at  the  same 
time  to  supply  the  banker  with  a  prior  lien  upon  the  goods. 
In  addition  to  entering  into  this  contract,  the  importer  will 
be  required  to  pay  commission  to  the  banker. 

The  credit  granted  by  the  American  bank  may  be  either 
revocable  or  irrevocable.  The  latter  is  used  only  in  those 
relatively  rare  instances  in  which  the  bank  is  dealing  with  a 
client  who  is  worthy  of  the  utmost  confidence.  An  irrevo- 
cable credit  binds  the  bank  to  perform  its  part  of  the  transac- 
tion regardless  of  changes  which  may  intervene  to  undermine 
the  security  of  the  importer's  Ijusiness,  and  thus  increases  the 
banker's  risk  of  loss.  Usually,  an  authority  to  purchase  is 
granted  on  the  understanding  that  it  may  be  recalled  by  the 
bank  when  there  is  reason  to  suspect  the  importer  of  intended 


252  FOREIGN  EXCHANGE 

bad  failli,  or  to  fear  an  unfavorable  turn  in  his  business  aflTairs; 
but  rovDcation  can  be  made  only  after  notice  lias  been  given 
by  the  bank,  and  cannot  extend  to  any  drafts  which  have 
previously  been  negotiated  by  its  foreign  correspondent, 

(6)  Relations  between  the  banks  created  by  the  authority  to 
'purchase.  The  foreign  bank  to  which  the  authority  to  pur- 
chase is  to  be  given  will  be  a  branch  or  a  correspondent  of  the 
importer's  bank  in  America,  the  two  having  entered  into  an 
agreement  covering  transactions  of  this  nature.  Notice  is 
sent  to  the  correspondent  usually  by  the  simple  expedient  of 
mailing  a  copy  of  the  letter  of  guarantee  to  which  is  appended 
the  request  that  the  correspondent  undertake  its  share  of  the 
operation.  In  the  practice  of  banks,  this  request  is  often 
merely  the  notation,  "Please  do  the  needful,"  or  words  of 
similar  brevity  written  on  the  back  or  at  the  bottom  of  the 
letter  of  guarantee. 

To  understand  the  relations  of  the  two  banks,  it  must  be 
made  clear  that  the  foreign  correspondent  is  acting  merely  as 
an  agent  for  the  bank  in  America,  and  not  as  its  partner  in 
a  profit-making  enterprise.  As  regards  the  foreign  corre- 
spondent, the  authority  to  purchase  is  permissive,  not  com- 
pulsory. The  foreign  bank  may  properly  refuse  to  engage  in 
the  transaction  at  all,  in  which  case  the  authority  fails  of  its 
intended  purpose  from  the  point  of  view  of  the  exporter,  for 
it  gives  him  no  power  to  enforce  by  legal  action  the  negotia- 
tion of  his  bills.  Many  exporters,  who,  in  their  ignorance  of 
the  real  nature  of  an  authority  to  purchase,  have  confused  it 
with  a  letter  of  credit,  have  learned  to  their  cost  that  bankers 
may  see  fit  to  disregard  requests  of  this  kind  and  refuse  to  buy 
the  drafts  for  which  the  merchants  believed  an  assured  market 
had  been  created.  However,  if  the  correspondent  does  buy 
the  drafts,  it  is  done  in  its  capacity  of  agent  for  the  account 
and  risk  of  the  American  bank  and  the  purchase  will  be  made 
out  of  funds  kept  on  deposit  by  the  American  bank.  When 
these  funds  prove  insufficient  to  cover  the  drafts,  the  author- 
ity to  purchase  will  in  most  instances  be  disregarded,  though 
it  is  possible  that  an  advance  may  be  made  by  the  corre- 
spondent upon  w^hich  interest  will  be  charged.   K  the  agree- 


OTHER  FORMS  OF  BANK  CREDIT  253 

ment  between  the  two  banks  is  one  of  long  standing,  it  may 
be  assumed  that  the  authority  to  purchase  will  be  faithfully 
exercised  by  the  correspondent.  The  risks  of  this  bank  are 
established  by  the  laws  of  agency  which  bind  it  not  to  exceed 
its  authority,  nor  to  violate  any  of  the  conditions  laid  down 
as  to  the  character  of  the  drafts  and  the  time  limits  within 
which  they  must  be  drawn.  For  its  services  the  correspond- 
ent will  receive  a  commission  proportioned  to  the  life  of  the 
drafts. 

(c)  Relationsbetweenthe  foreign  bank  and  the  exporter.  Un- 
less instructed  to  do  so,  the  foreign  correspondent  will  not  be 
bound,  by  the  receipt  of  an  authority  to  purchase,  to  inform 
the  exporter  of  its  willingness  to  purchase  his  bills.  The  lat- 
ter, of  course,  will  have  been  in  communication  wuth  his  Amer- 
ican customer  and  it  can  be  assumed  that  he  will  have  been 
notified  of  the  arrangement  made  for  financing  the  shipment; 
but  it  may  be  left  to  him  to  take  the  initiative  in  obtaining 
specific  information  from  his  banker.  In  case  the  banker  has 
been  instructed  to  confirm  the  transaction,  the  character  of 
his  confirmation  will  depend  somewhat  upon  whether  or  not 
the  credit  has  been  made  irrevocable,  and  also  upon  his  own 
willingness  to  bind  himself  as  agent  in  an  irrevocable  manner. 
The  letter  received  by  the  exporter  in  confirmation  of  the 
authority  will  be  either  in  the  form  of  an  authority  to  draw  or  a 
notification  of  advice,  according  to  the  degree  of  obligation 
which  the  banker  wishes  to  assume.  The  following  is  a  typ- 
ical authority  to  draw: 

Manila  Branch  op  the  New  York  Bank 

Manila,  August  3, 1921 
Philippine  Export  G). 

Manila,  P.I.  . 

Dear  Sirs: 

I  beg  to  inform  you  that  I  am  instructed  by  the  Manager  of  our 
branch  at  New  York  to  purchase,  as  offered, 


254  FOREIGN  EXCHANGE 

your  D/P  bills  drawn  at  CO  days  sight  up>on 

American   Importing   Co.  to    the  extent  of 

one  thousand  dollars  for  the  invoice  cost  of        sugar 

shipped  to  that  port. 

The  bills  must  be  accompanied  by  full  sets  of  bills  of  lading  made 
out  to  order,  endorsed  in  blank  and  marked  by  the  shipping  company, 
"freight  paid,"  together  with  invoices  and  policies  of  insurance,  all 
duly  hj-pothecated  to  the  bank  against  the  payment  of  the  bills. 

Please  note  that  this  is  not  to  be  considered  a  Bank  Credit  and  does 
not  relieve  you  from  the  liability  usually  attaching  to  the  drawer  of  a 
bill  of  exchange. 

Bills  drawn  under  the  above-mentioned  instructions  must  be 
plainly  marked  "drawn  under  your  letter  of  authority  no.  1000" 

and  must  be  accompanied  by  this  letter  that  the  axQount  of  the  same 
may  be  endorsed  on  the  back.  . 

Yours  tridy,. 
manager. 

^special  attention  is  called  to  the  third  paragraph  of  this 
letter  which  lays  stress  upon  the  exporter's  liability  as  drawer 
of  the  bills,  for  therein  is  expressed  an  essential  distinction 
between  a  guaranty  to  purchase  and  a  letter  of  credit.  In 
the  case  of  a  true  bank  credit,  the  right  of  recourse  by  a  nego- 
tiating banker  does  not  lie  against  the  drawer  because  of  any 
failure  of  the  importer  to  discharge  his  obligations  to  the  bank 
which  issues  the  letter;  recourse  can  be  had  against  the  drawer 
only  in  one  case,  namely,  failure  of  the  accepting  bank.  But 
by  the  terms  of  the  letter  of  authority,  the  right  to  draw  is 
said  to  be  no  bank  credit,  and  the  legal  right  of  recourse  to 
the  drawer  is  made  identical  with  that  of  any  commercial 
bill,  being  conditioned  upon  the  failure  of  the  drawee  to  dis- 
charge his  obligations.  It  is  sometimes  the  practice  to  issue 
these  authorities  to  purchase  vnihout  recourse  to  the  drawer. 
In  thjs  case,  the  purchasing  bank  will  include  in  the  letter  of 
authority  some  such  words  as  the  following:  "We  are  author- 
ized to  honor  your  drafts without  recourse  to 

yourselves.''    This  places  the  drawer  in  the  same  position  as 


OTHER  FORMS  OF  BANK  CREDIT  Q55 

the  beneficiary  of  the  letter  of  credit,  and  increases  the  risk 
of  the  bank  which  issues  the  authority.  An  extra  commission 
is  properly  charged  the  importer  for  his  additional  risk. 

The  letter  as  phrased  in  the  example  given  is  virtually  a 
contract  giving  the  exporter  complete  assurance  of  his  ability 
to  sell  the  bills  drawn  according  to  its  terms.  Usually,  as  has 
been  said,  the  authority  is  made  revocable  at  the  option  of 
the  granting  bank,  in  which  case  the  letter  will  vary  slightly 
from  the  form  given  above,  including  in  the  text  some  such 
statement  as  the  following: 

This  letter  is  for  your  guidance  in  preparing  the  documents  and 
conveys  no  engagement  on  the  part  of  the  bank.    Although  it  is 

considered  to  be  open six  months from ....  July  18 . .  . . 

it  may  be  cancelled  by  us  on  giving  you  notice. 

The  receipt  of  a  qualified  confirmation  will  inform  the  ex- 
porter that  his  bills  w^ill  probably  be  bought,  but  does  not 
bestow  upon  him  any  legal  right.  In  general  practice,  how- 
ever, it  may  safely  be  assumed  that  he  will  meet  with  no  re- 
fusal to  purchase  if  his  drafts  are  drawn  in  conformity  with 
the  instructions. 

The  buying  price  for  the  exporter's  bills  will  be  somewhat 
affected  by  the  terms  of  the  letter  of  guarantee  which  defines 
the  importer's  obligations  to  the  American  bank.  In  the 
specimen  letter  of  guarantee  which  we  have  given  above,  it 
will  be  noted  that  the  importer  engages  to  pay  interest  at  six 
per  cent  during  the  life  of  each  acceptance  from  the  day  it  is 
drawn  until  he  redeems  it.  These  terms  obviate  the  necessity 
of  discounting  the  exporter's  bill  when  bought  by  the  Manila 
correspondent,  thus  providing  for  the  determination  of  the 
purchase  price  on  the  basis  of  the  sight  rate  of  exchange  be- 
tween Manila  and  New  York.  But  the  full  sight  rate  will  not 
be  paid  for  the  bill  in  any  case;  the  banker's  demand  draft, 
to  which  the  sight  rate  applies,  is  of  higher  standing  than  any 
credit  instrument  which  one  merchant  can  draw  upon  another, 
and  is  negotiated  by  the  bankers  on  more  favorable  terms. 
The  exporter,  therefore,  will  sell  his  bill  at  a  rate  slightly 
lower  than  the  sight  rate,  the  exact  spread  between  the  two 


25G  FOREIGN  EXCHANGE 

prices  measuring  the  credit  standing  of  the  two  merchants 
party  to  the  transaction. 

We  may  now  illustrate  the  foregoing  discussion  by  a  typical 
transaction.  Assume  that  the  American  Importing  Company 
has  bought  one  thousand  dollars'  worth  of  sugar  from  the 
Philippine  Export  Company  in  Manila,  agreeing  to  supply 
the  sellers  with  an  authority  to  purchase  under  which  they 
may  draw  at  sixty  days'  sight  against  the  importers.  The 
authority  is  obtained  from  a  New  York  bank  after  the  im- 
porters have  acceded  to  the  conditions  of  a  letter  of  guarantee. 
If  the  matter  is  urgent,  a  cable  will  be  sent  to  the  INIanila 
correspondent  apprising  him  of  his  authority  to  purchase, 
the  importers  bearing  the  extra  cost ;  otherwise,  a  copy  of  the 
letter  of  guarantee  will  be  mailed  for  the  information  of  the 
Manila  bank.  In  due  course,  the  Philippine  Export  Com- 
pany will  receive  a  letter  granting  permission  or  authority 
to  draw.  The  ground  is  now  laid  for  the  shipment  of  the 
sugar.  The  goods  are  insured  and  placed  aboard  an  outgoing 
steamer  by  the  exporters,  who  then  draw  a  draft  for  one  thou- 
sand dollars  against  the  American  Importing  Company,  at- 
tach to  it  bills  of  lading,  invoice,  and  insurance  policy,  and 
deliver  the  resulting  documentary  commercial  bill  to  the 
Manila  bank.  Upon  receiving  the  equivalent  of  one  thousand 
dollars  in  pesos  at  the  ruling  rate  of  exchange,  the  exporters 
are  freed  from  the  transaction,  though  they  bear  the  con- 
tingent liability  of  a  drawer  of  a  bill  of  exchange.  The  Manila 
bank  charges  the  purchase  price  against  the  balance  of  the 
New  York  bank  and  sends  the  documentary  bill  forward  by 
mail  steamer;  it  arrives  prior  to  the  arrival  of  the  freight 
steamer  which  brings  the  sugar  and  is  presented  for  accept- 
ance. When  the  time  comes,  a  trust  receipt  may  be  employed 
to  release  the  bills  of  lading  prior  to  payment  by  the  importers, 
or  the  acceptance  may  be  prepaid  by  them  as  a  condition  of 
obtaining  the  sugar,  or  the  goods  may  be  stored  by  the  New 
York  bank  until  the  acceptance  matures.  These  details  will 
be  settled  by  negotiation  between  the  bank  and  the  importer. 
Payment  of  the  acceptance  with  interest  will  clear  the  im- 
porters from  all  obligation  under  their  letter  of  guarantee  and 
bring  the  transaction  to  a  close. 


OTHER  FORMS  OF  BANK  CREDIT  257 

Failure  on  the  part  of  the  Importing  Company  to  pay  its 
acceptance  would  throw  the  New  York  hank  upon  a  number 
of  expedients  for  the  recovery  of  the  money  laid  out  in  the 
purchase  of  the  bill.  If  the  sugar  had  been  stored,  or  if  any 
portion  of  it  remained  in  the  possession  of  the  bank,  it  would 
be  sold  and  the  proceeds  applied  to  the  importer's  debt;  ac- 
tion would  be  brought  on  the  basis  of  the  contract  comprised 
in  the  letter  of  guarantee;  and,  in  the  final  instance,  recourse 
would  be  had  to  the  drawer  of  the  bill  of  exchange.  The  im- 
porter, as  has  been  said,  bears  all  risk  of  misconduct  on  the 
part  of  the  Export  Company.  If  the  sugar  is  of  inferior  qual- 
ity, or  short  in  weight,  the  bank  will  not  release  the  importer 
from  his  obligation  to  redeem  the  acceptance,  nor  aid  him  in 
recovering  damages  from  the  Philippine  shippers.  Recovery 
must  be  effected  by  action  brought  on  the  basis  of  the  sales 
contract,  and  the  importer  must  bear  the  costs  involved  in 
legal  action. 

59.  Relation  of  bank  credits  to  the  exchange  market.  Em- 
ployment of  any  of  these  different  methods  of  financing  inter- 
national trade  may  appear  at  first  sight  to  break  the  connec- 
tion between  the  movement  of  wares  between  the  nations  and 
the  demand  and  supply  of  bills  of  exchange  in  the  markets. 
But  reflection  will  show  that  this  is  not  really  true:  every 
shipment  of  goods,  however  financed,  either  increases  the 
supply,  in  the  exporter's  market,  of  liills  drawn  on  a  foreign 
center,  or  the  demand  in  the  importer's  market  for  foreign 
bills.  By  the  intervention  of  the  banks,  the  obligation  usu- 
ally borne  by  buyer  or  seller  to  draw  or  remit  foreign  bills  of 
exchange  is  sometimes  taken  by  the  bankers;  this  is  the  case 
when  a  bank  credit  is  established  by  the  importer  in  favor  of 
the  exporter  in  his  own  market:  the  duty  of  remitting  funds 
between  the  two  markets  is  assumed  by  the  importer's  banker. 
When  an  acceptance  credit  is  established  by  the  exporter's 
banker  in  his  favor,  the  exporter  receives  payment  for  his 
goods  from  some  money-lender  in  his  own  market;  but  his 
collection  draft,  which  serves  as  collateral  for  the  acceptance 
credit,  produces  an  inflow  of  funds  into  the  hands  of  the  for- 
eign correspondent  to  be  expended  in  the  purchase  of  drafts 


258  FOREIGN  EXCHANGE 

for  remittance  to  the  exporter's  banker.     In  the  case  of  an 

authority  to  purchase,  the  exporter's  bill  is  passed  through 
two  funds,  both  belonging  to  the  importer's  banker:  the  for- 
eign balance  in  the  hands  of  the  correspondent  abroad  and  the 
cash  supply  at  home;  the  completed  transaction  reduces  the 
foreign  balance  when  the  bill  is  bought  and  increases  the  cash 
supply  in  the  home  office  when  the  acceptance  is  redeemed  by 
the  importer.  In  order  to  engage  in  transactions  of  this  kind, 
the  importer's  bank  must  repair  his  foreign  balance  by  buying 
drafts  for  remittance  to  its  correspondent. 


CHAPTER  X 

SERVICES  OF  BILLS  OF  EXCHANGE  IN  FOREIGN 
TRADE 

60.  Summary  of  the  methods  of  making  payment  by  means 
of  bills  of  exchange.  We  have  now  concluded  our  study  of 
the  usual  ways  in  which  payment  may  be  made  by  means  of 
bills  of  exchange  in  international  commercial  transactions. 
It  will  be  our  purpose  in  the  present  chapter  to  analyze  the 
services  of  commercial  bills  of  exchange  to  the  business  men 
who  engage  in  foreign  trade,  and  to  discuss  some  of  the  prob- 
lems encountered  by  those  who  use  them.  Before  proceeding 
to  this  task,  however,  it  may  be  of  use  to  summarize  the  dif- 
ferent kinds  of  bills  employed  in  international  commerce. 
In  a  typical  transaction  payment  may  be  made  in  any  one  of 
the  following  ways: 

A.  By  bill  of  exchange  drawn  by  the  seller. 

I.  Drawn  against  the  buyer  in  the  buyer's  money. 
II.  Drawn  against  the  buyer  requiring  a  return  draft  in 
the  seller's  money  or  in  the  money  of  a  third  country. 
III.  Drawn  against  the  buyer  and  supported  by  an 
authority  to  purchase. 

The  foregoing  bills  all  result  in  trade  acceptances; 
with  regard  to  form  they  may  be  either: 

(a)  Clean  bills.     Goods  delivered  to  buyer  upon 

arrival;  or, 
(6)  Documentary  acceptance  bills.     Goods  de- 
livered upon  acceptance;  or, 
(c)  Documentary    payment    bills.     Goods    de- 
livered either 

(1)  upon  payment;  or, 

(2)  upon  prepayment  with  rebate  of  in- 
terest; or, 

(3)  in  advance  of  payment  under  trust 
receipt  or  other  security. 


260  FOREIGN  EXCHANGE 

IV.   Drawn  against  a  banker  under  letter  of  credit  or 
other  bank  credit. 

(a)  The  credit  is  estabUshed  by  the  buyer  in 
favor  of  the  seller  with  a  banker  located 
either  in  the  seller's  country;  or  in  the  buy- 
er's; or  in  a  third  country.  The  bills  are 
drawn  in  the  money  of  the  country  in  which 
the  bank  is  located. 

(b)  The  bills  are  almost  always  documented;  if 
long  bills,  the  documents  are  always  sur- 
rendered against  acceptance  to  the  accepting 
banker,  and  by  this  banker  to  the  buyer 
upon  payment;  prepayment;  or,  in  advance 
of  payment,  under  trust  receipt  or  other  se- 
curity. 

B.  Remittance  of  a  bill  of  exchange  by  the  buyer  to  the 
seller. 
I.  The  remittance  is  almost  invariably  a  banker's 
bill,  and  usually  a  demand  draft  or  cable;  in  rare 
cases  a  banker's  long  bill. 
II.  The  bill  may  be  drawn  in  the  buyer's  money,  or  in 
the  seller's,  or  in  the  money  of  a  third  country. 
6i.  Distribution  of  risk  by  means  of  bill  of  exchange. 
Since  the  bill  of  exchange  may  be  said  to  represent  the  buyer's 
attempt  to  meet  the  seller's  terms  in  the  least  expensive  and 
most  convenient  manner,  it  will  aid  us  in  understanding  the 
services  of  bills  of  exchange  to  the  world's  business  men  to 
examine  briefly  the  terms  of  sale  customary  in  foreign  trade. 
The  expression  "terms  of  sale"  embraces  two  very  different 
elements.     In  constructing  his  terms,  the  seller  must,  in  the 
first  place,  set  a  price  upon  his  goods;  in  the  second  place,  he 
must  instruct  prospective  buyers  as  to  acceptable  methods  of 
payment.     The  first  of  these  problems  does  not  greatly  con- 
cern us.    Although  the  exporter's  method  of  pricing  his  goods 
has  some  bearing  upon  the  character  of  the  bill  of  exchange 
used  to  make  payment  in  the  transaction,  and  upon  the  costs 
and  receipts  of  importer  and  exporter,  we  may  well  postpone 
inquiry  into  this  relationship  to  a  later  place.     It  is  with  the 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       261 

other  element  in  the  terms  of  sale  that  we  have  to  do  at  pres- 
ent; for  in  advising  foreign  buyers  of  the  forms  of  payment 
which  he  will  accept,  the  exporter  determines  the  buyer's 
range  of  choice  with  regard  to  the  bill  of  exchange  which  may 
be  employed  as  an  adjunct  to  the  transaction. 

In  making  an  agreement  with  respect  to  the  method  of  pay- 
ment, buyer  and  seller  must  solve  an  important  problem  in- 
herent in  all  international  commercial  transactions :  the  prob- 
lem of  the  distribution  of  the  risk.  The  transaction  is  exposed 
to  risk  of  loss  from  three  sources:  (a)  failure  or  malpractice 
on  the  part  of  the  banks  which  handle  the  financing  docu- 
ments; (6)  fluctuations  of  the  rates  of  exchange  which  ad- 
versely affect  the  costs  and  receipts  of  the  two  parties;  (c) 
business  failure  or  bad  faith  on  the  part  of  either  buyer  or 
seller.  The  first  of  these  risks  is  so  slight  that  business  men 
habitually  leave  it  out  of  account;  we  shall  do  the  same.  The 
second,  called  the  "risk  of  exchange,"  is  present  whenever 
either  party  makes  commitments  whose  costs  are  governed 
by  the  position  of  the  exchange  rate  on  a  future  day,  or  under- 
goes costs  in  consideration  of  a  deferred  return  whose  amount 
varies  with  the  future  fluctuations  of  the  rate.  Examination 
of  this  risk  and  of  the  methods  of  guarding  against  it  will  be 
made  in  section  63.  The  third  hazard  we  may  call  the  "  mer- 
cantile risk."  The  seller  is  exposed  to  risk  of  loss  through 
failure  or  bad  faith  on  the  part  of  the  buyer  whenever  he  buys 
goods,  pays  wages,  or  assumes  other  costs  on  the  strength  of 
an  order  received  from  the  buyer  unsupported  by  advance 
payment  of  cash;  or  surrenders  his  goods  against  the  buyer's 
acceptance  of  a  long  bill  of  exchange  in  whose  negotiation  he 
bears  the  liability  of  drawer;  or  surrenders  the  goods  expecting 
to  receive  payment  at  a  later  date  by  remittance  from  the 
buyer.  The  buyer  bears  a  similar  risk  whenever  he  pays 
cash  at  the  time  of  placing  his  order  and  relies  upon  the  good 
faith  and  business  solvency  of  the  seller  to  secure  a  satisfac- 
tory filling  of  the  order;  or  makes  a  payment  or  an  accept- 
ance in  order  to  obtain  the  shipping  documents,  before  he  has 
had  opportunity  to  inspect  the  goods;  or  binds  himself  to 
make  a  deferred  payment  regardless  of  the  performance  of 


2C2  FOREIGN  EXCILVNGE 

the  seller  (as  in  the  case  of  a  contract  for  a  letter  of  credit). 
The  terms  of  sale  may  call  for  a  method  of  payment  which 
will  throw  this  risk  entirely  upon  the  seller;  or  entirely  upon 
the  buyer;  or  will  divide  it  between  them. 

Althouf^h  the  terms  of  sale  in  foreign  trade  vary  so  widely 
as  to  forbid  rigid  classification,  we  may  divide  them  roughly 
into  the  following  groups: 

A.  Terms  requiring  advance  payment  by  the  importer. 

B.  Terms  requiring  payment  by  the  importer  upon  de- 
livery of  the  goods. 

C  Terms  providing  for  deferred  payment  by  the  importer. 

A.  Advance  payment  by  the  importer.  The  buyer  makes 
an  advance  payment  whenever  he  accedes  to  the  following 
terms:  cash  with  order;  cash  against  documents  at  the  ship- 
ping point;  documentary  sight  draft.  To  remit  cash  with  his 
order,  the  buyer  procures  a  demand  draft  payable  by  a  bank 
in  the  seller's  market,  or  by  a  bank  in  a  third  country,  if  this 
is  acceptable  to  the  seller.  Upon  receipt  of  this  remittance, 
the  goods  are  prepared  for  shipment,  and  consigned  to  the 
buyer  to  whom  the  shipping  documents  are  sent  by  direct 
mail.  Thus  the  buyer  makes  an  advance  of  funds  from  the 
time  of  placing  his  order  until  the  arrival  of  the  shipment;  the 
seller,  on  the  other  hand,  having  cash  in  hand  before  taking 
the  initial  step  in  filling  the  order,  makes  no  advance  at  all; 
nor  does  he  bear  any  risk.  Since  the  buyer  has  parted  with 
his  money  before  inspecting  the  goods,  and,  indeed,  before 
they  have  been  prepared  for  shipment,  his  only  recourse  in 
case  the  order  is  not  filled  or  the  goods  prove  to  be  of  bad 
quality,  or  of  short  weight,  or  not  what  was  ordered,  is  to 
recover  damages  by  bringing  legal  action  against  the  seller  on 
the  basis  of  the  contract  of  sale.  Terms  so  burdensome  to  the 
buyer  are  the  exception  to  the  rule  in  foreign  trade,  but  are 
employed  occasionally  in  transactions  of  minor  importance 
between  firms  which  have  no  regular  dealings  with  each  other. 

Cash  against  documents  at  the  shipping  point  are  terms 
requiring  the  importer  to  provide  payment  at  the  designated 
point  whenever  the  seller  is  prepared  to  surrender  shipping 
documents  —  invoices,  bills  of  lading,  insurance  policy  —  to 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       263 

show  that  the  goods  have  been  delivered  to  the  transportation 
company.  This  is  usually  done  through  the  establishment  of 
a  bank  credit  in  the  exporter's  market,  unless  the  importer 
has  his  own  agent  in  that  market  and  can  make  the  payment 
through  him.  If  payment  is  to  be  made  by  means  of  bank 
credit,  the  importer  will  usually  be  required  to  pay  cash  to  his 
own  banker  at  the  time  of  placing  the  order,  and  either  in- 
form the  exporter  of  the  arrangement,  naming  the  bank  which 
is  instructed  to  make  the  payment  in  exchange  for  shipping 
documents,  or  request  this  bank  to  confirm  the  credit. 

A  bank  credit  of  this  kind,  confirmed  and  made  irrevocable 
by  the  bank,  relieves  the  seller  from  all  mercantile  risks,  since 
he  can  obtain  the  money  for  his  goods  by  showing  the  proper 
shipping  documents,  regardless  of  the  performance  of  the  im- 
porter. In  many  cases,  he  obtains  payment  without  the 
formality  of  drawing  a  draft,  merely  exchanging  the  shipping 
documents  for  the  necessary  amount  of  cash  at  the  office  of 
the  banker;  this  sets  him  clear  of  the  transaction  without 
liability  to  make  restitution.  When  he  does  draw  a  draft,  it 
is  usually  negotiated  witlwut  recourse  to  himself  in  case  of 
non-performance  by  the  drawee.  In  possession  of  a  con- 
firmed bank  credit,  the  seller  has  a  contract  which  binds  the 
bank  to  make  payments  under  certain  prescribed  conditions; 
his  risk  of  loss  is  limited  to  risk  of  failure  on  the  part  of  the 
hanky  only.  An  unconfirmed  credit,  and  one  which  is  revo- 
cable at  the  option  of  banker  or  buyer,  increases  the  seller's 
risk  to  this  extent,  that  up  to  the  point  of  shipping  the  goods 
he  has  no  enforceable  right  of  negotiation  of  his  drafts,  and 
must  bear  any  costs  assumed  in  preparing  the  goods  for  ship- 
ment with  a  chance  that  the  credit  will  be  revoked  or  the 
banker  will  refuse  to  obey  the  buyer's  instructions  to  make 
payment.  It  is  apparent  that  these  methods  of  payment 
place  the  burden  of  mercantile  risk  almost  solely  upon  the 
buyer;  yet  his  risk  is  not  as  great  as  when  he  remits  cash  with 
order.  His  money  is  not  paid  over  to  the  seller  until  shipment 
is  made,  which  assures  him  that  his  order  has  been  filled;  but 
he  has  no  adequate  safeguard  against  bad  faith  which  results 
in  the  shipment  of  inferior  goods,  or  of  goods  improperly 


264  FOREIGN  EXCIL\NGE 

packed,  unless  he  maintains  an  agent  in  the  seller's  market 
who  can  inspect  the  shipment. 

A  documentary  sight  draft  divides  the  risk  between  buyer 
and  seller.  The  exporter  must  fill  the  order  on  the  strength 
of  the  buyer's  promise  to  make  payment,  contained  in  the 
contract  of  sale;  in  assuming  costs  in  connection  with  the 
transaction,  he  not  only  places  confidence  in  the  good  faith 
of  the  buyer,  but  also  shares  with  other  creditors  a  stake  in 
the  hazards  of  the  buyer's  business,  since  business  reverses 
may  intervene  to  prevent  the  buyer's  making  payment  de- 
spite the  best  of  intentions  on  his  part.  These  risks  the  seller 
cannot  evade  by  selling  his  sight  draft  to  the  bankers,  for  he 
will  continue  liable  as  drawer  until  payment  is  made.  The 
goods  must  be  shipped  before  the  draft  can  be  documented  as 
required  by  the  terms  of  sale;  refusal  to  honor  the  draft  will, 
therefore,  throw  the  goods  back  upon  the  seller's  hands  in  a 
foreign  market  where  it  will  be  diflficult  to  dispose  of  them 
without  loss.  The  buyer,  on  his  side,  makes  an  advance  pay- 
ment the  length  of  which  is  determined  by  the  discrepancy 
between  mail  and  freight  time  which  brings  the  sight  draft  to 
his  market  in  advance  of  the  goods.  Since  the  draft  is  docu- 
mented, the  buyer  need  not  make  payment  before  he  is  as- 
sured that  the  order  has  been  filled,  but  he  is  not  accorded  an 
opportunity  to  inspect  the  shipment  to  determine  its  suffi- 
ciency as  to  quality  and  quantity.^ 

In  the  three  methods  of  payment  which  result  in  payment 
in  advance  of  delivery,  it  will  be  noted  that  the  recourse  of  the 
injured  party  is  to  bring  legal  action  against  the  offender  on 
the  basis  of  the  contract  of  sale.  To  illustrate,  let  us  consider 
the  procedure  in  case  the  documentary  sight  draft  is  not  hon- 
ored by  the  buyer.  The  seller  has  not  lost  possession  of  his 
goods,  but  he  is  almost  certain  to  lose  money  in  case  he  cannot 
force  their  acceptance  upon  the  buyer  and  compel  the  latter 
to  pay  the  sight  draft.  Suppose  the  buyer  is  guilty  of  bad 
faith  and  the  seller  wishes  to  recover  damages;  what  recourse 

*  We  assume  in  making  this  statement  of  the  buyer's  risk  that  the  sight 
draft  is  presented  for  payment  upon  arrival  according  to  the  strict  interpreta- 
tion of  its  terms. 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       265 

has  he?  He  holds  no  financing  instrument  which  bears  the 
buyer's  signature  acknowledging  a  debt  of  a  certain  definite 
amount  and  promising  payment  at  a  stated  time,  such  as  he 
would  have  if  the  buyer  had  accepted  a  bill  of  exchange.  His 
only  claim  against  the  buyer  must  be  based  upon  the  contract 
of  sale.  Now,  there  is  an  important  difference  between  the 
task  of  the  seller  when  attempting  to  enforce  a  contract  of 
sale  and  his  task  when  attempting  to  collect  an  accepted  bill 
of  exchange.  In  the  latter  case,  he  need  only  prove  +he  valid- 
ity of  the  buyer's  signature;  he  is  not  required  to  defend  the 
different  items  which  are  included  in  the  total  amount  stated 
on  the  face  of  the  bill.  In  the  former,  he  must  not  only  prove 
that  the  goods  were  ordered,  but  also  that  the  order  was  filled 
faithfully,  and  that  every  item  included  in  his  claim  is  a  valid 
charge  against  the  buyer.  It  must  be  remembered,  moreover, 
that  his  suit  will  be  brought  in  a  foreign  court  and  under  for- 
eign laws,  circumstances  which  make  it  difficult  for  the  plain- 
tiff to  inform  himself  with  regard  to  his  exact  legal  rights  and 
the  procedure  required  to  defend  them,  and  which  subject 
him  to  heavy  charges  in  the  form  of  court  fees.  A  similar 
burden,  of  course,  is  borne  by  the  buyer  when  attempting  to 
recover  damages  from  the  seller  by  proceedings  instituted  on 
the  basis  of  the  contract  of  sale,  as  he  must  do  if  the  goods, 
which  arrive  after  he  has  paid  the  draft,  prove  to  be  unac 
ceptable. 

B.  Payment  by  the  importer  upon  delivery  of  the  goods.  In 
the  vast  majority  of  cases,  the  buyer  of  goods  in  foreign  trade 
is  offered  more  liberal  terms  than  those  just  discussed.  To 
exact  payment  before  receipt  of  the  goods  would,  under 
normal  conditions,  so  weaken  the  seller's  competing  power  in 
comparison  with  merchants  who  were  prepared  to  accord  less 
burdensome  terms  to  the  buyer,  that  he  would  find  great  dif- 
ficulty in  developing  a  foreign  market.  Somewhat  more 
liberal  than  payment  in  advance  are  terms  which  require 
payment  by  the  importer  upon  receipt  of  the  goods.  Such 
terms  place  the  chief  burden  of  risk  upon  the  seller.  He  will 
have  assumed  costs  in  preparing  the  goods  for  shipment  on 
the  strength  of  the  buyer's  promise  to  pay  after  inspection; 


2G6  FOREIGN  EXCHANGE 

nltliough  he  retains  ownership  in  tlie  goods  until  payment  is 
made,  insolvency  or  malpractice  of  his  customer  will  leave 
him  with  the  goods  on  his  hands  in  a  distant  city  and  subject 
to  the  expense  of  reshi{)ment,  or  resale  to  another  buyer  in 
the  same  market.  Whether  the  importer  bears  any  part  of 
the  risk  depends  upon  the  method  of  payment  selected  by  the 
two  parties. 

The  purpose  of  postponing  payment  until  delivery  has  been 
made  to  the  buyer  is  usually  effected  in  one  of  four  ways. 
Sometimes  the  documentary  sight  draft  is  governed  by  docu- 
mentary instructions  which  permit  postponement  of  presenta- 
tion until  the  goods  have  arrived.  In  certain  markets,  notably 
South  American,  business  custom  demands  that  this  post- 
ponement be  made;  importers  simply  refuse  to  honor  sight 
drafts  until  the  goods  have  arrived  in  port,  and  the  bankers 
handle  such  bills  in  full  knowledge  of  this  procedure.  Sur- 
render of  the  documents  upon  payment  of  the  draft  gives  the 
buyer  possession  of  the  goods  upon  arrival ;  from  his  point  of 
view,  the  transaction  will  have  been  resolved  into  a  cash  on 
delivery  sale  in  which  he  has  adequate  defense  against  bad 
faith  on  the  part  of  the  seller.  The  latter  bears  the  risk;  his 
only  recourse  is  to  attempt  recovery  on  the  basis  of  the  con- 
tract of  sale.  Obviously,  this  adaptation  of  the  sight  draft 
virtually  resolves  it  into  a  bill  drawn  for  an  indeterminable 
number  of  days  after  date,  thus  violating  the  prescription  of 
the  law  that  bills  of  exchange  must  be  payable  at  "a  fixed  or 
determinable  future  time." 

Another,  and  more  direct,  method  of  accomplishing  this 
result  is  for  the  seller  to  give  the  bankers  a  "letter  of  delega- 
tion" which  empowers  them  to  collect  the  amount  due  from 
the  buyer  upon  arrival  of  the  goods.  A  delegation  is  a  docu- 
ment through  which  one  party  transfers  to  another  certain  le- 
gal rights  which  he  possesses  —  in  this  case,  the  right  to  collect 
a  sum  of  money  from  a  designated  party  under  certain  stated 
conditions.  The  correspondent  banker  in  the  buyer's  market 
will  be  bound  by  the  instructions  written  into  the  letter  of 
delegation,  but  within  the  limits  thus  set  he  will  be  free  to  act 
in  the  role  of  the  seller  to  whom  payment  is  due.  The  use  of 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       267 

the  letter  of  delegation  obviates  the  drawing  of  a  sight  draft 
by  the  exporter;  the  letter,  itself,  is  not  a  bill  of  exchange  and 
thus  is  not  subject  to  the  restrictions  which  the  laws  of  differ- 
ent nations  place  upon  the  bill  of  exchange.  This  method  is 
sometimes  adopted  to  avoid  the  payment  of  stamp  taxes 
which  certain  countries  levy  upon  bills  of  foreign  origin. 
From  the  point  of  view  of  the  buyer,  payment  effected  in  this 
manner  is  equivalent  to  cash  against  documents  in  the  buyer's 
market  upon  arrival  of  the  goods.  The  risk,  again,  is  borne 
by  the  seller  whose  recourse  is  to  bring  action  under  the  con- 
tract of  sale  in  the  courts  of  the  buyer's  country. 

A  third  method  of  according  the  buyer  opportunity  to  pay 
cash  upon  delivery  is  the  use  of  a  documentary  payment  bill 
with  the  option  of  prepayment.  In  most  markets,  it  is  now 
the  recognized  practice  to  allow  a  rebate  of  interest  upon  the 
prepayment  of  these  bills,  and  they  are  employed  in  consider- 
able numbers  by  importers  who  wish  to  conduct  their  transac- 
tions upon  a  cash  on  delivery  basis.  They  have  the  additional 
advantage  of  allowing  the  importer  the  alternative  of  post- 
poning payment,  and  the  receipt  of  the  goods,  in  cases  where 
the  market  is  not  favorable  to  a  quick  turn-over  of  the  trans- 
action. When  other  methods  are  employed  to  place  the 
transaction  upon  a  cash  on  delivery  basis,  delivery  of  the 
goods  is  forced  upon  the  buyer  at  the  time  of  their  arrival  in 
his  market;  the  payment  draft,  however,  places  in  his  hands 
power  to  regulate  the  time  of  delivery  in  accordance  with  the 
needs  of  his  business  while  yet  avoiding  payment  in  ad- 
vance.^ This  method  makes  a  somewhat  different  distribu- 
tion of  the  risk  than  does  the  documentary  sight  draft  or  the 
letter  of  delegation.  The  buyer,  though  he  makes  no  pay- 
ment in  advance  of  receipt  of  the  goods,  does  make  an  ad- 
vance acceptance,  thus  subjecting  himself  to  more  difficult 
defense  against  loss  through  bad  faith  on  the  part  of  the  seller; 
the  latter,  for  the  same  reason,  is  in  possession  of  a  better 
means  of  defense,  since  he  now  has  recourse  to  action  on  the 
basis  of  the  acceptance.  It  is  sometimes  the  practice  to  re- 
lieve the  buyer  of  this  risk  by  postponing  presentation  of  the 
1  See  the  discussion  of  the  payment  draft  on  pages  18G  f. 


2C8  FOREIGN  EXCHANGE 

bill  for  acceptance  until  the  arrival  and  inspection  of  the 
goods. 

A  fourth  method  of  payment,  similar  to  the  one  just  de- 
scribed, is  afforded  by  the  bill  of  exchange  drawn  for  a  short 
period  after  date.  The  tenor  of  this  bill,  computed  from  the 
time  of  drawing  by  the  exporter,  will  be  based  by  the  drawer 
upon  the  freight  time  between  his  market  and  that  of  the 
buyer.  With  the  advent  of  freight  liners  running  strictly  to 
schedule  time,  it  has  become  possible  to  foretell  with  con- 
siderable accuracy  how  great  an  interval  will  elapse  between 
the  shipment  of  the  goods  and  their  arrival,  and  this  improve- 
ment of  marine  transportation  is  causing  a  greater  use  of 
after-date  bills,  in  substitution  for  payment  sight  bills,  by 
importers  who  habitually  prepay  their  acceptances.  Any 
mistake  in  computing  the  maturity  of  the  bill,  which  would 
result  in  payment  in  advance  of  delivery,  is  usually  corrected 
by  withholding  the  bill  from  presentation  for  payment  un- 
til the  arrival  of  the  goods.  Acceptance  of  this  type  of  bill 
is  made  prior  to  the  arrival  of  the  goods;  hence,  it  effects  the 
same  distribution  of  risk  between  buyer  and  seller  as  does  the 
documentary  payment  draft. 

C.  Deferred  'payment  by  the  importer.  Deferred  payment,  as 
the  term  is  here  used,  means  payment  deferred  after  the  re- 
ceipt of  goods  by  the  importer.  Two  methods  are  usually 
employed  to  accomplish  this  result.  The  first  of  these  is  the 
documentary  acceptance  bill  which  permits  the  buyer  to  gain 
possession  of  the  shipping  documents  upon  acceptance,  and 
of  the  goods  upon  their  arrival  by  freight  steamer  some  time 
later.  Unless  the  acceptance  bill  is  drawn  under  a  letter  of 
credit  —  that  is,  in  all  cases  where  it  results  in  a  trade  accept- 
ance —  the  risks  of  the  transaction  fall  chiefly  upon  the  seller. 
He  is  required  to  prepare  the  goods  for  shipment  and  look  for 
his  defense  against  refusal  of  the  buyer  to  accept  his  bill  to 
his  rights  under  the  contract  of  sale;  he  surrenders  the  goods 
against  the  buyer's  acceptance  upon  which  he  must  depend 
to  enforce  payment  in  case  of  default  at  the  maturity  of  his 
bill.  The  buyer  is  usually  called  upon  to  make  the  accept- 
ance before  he  has  had  opportunity  to  inspect  the  goods. 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       2C9 

though  the  documentary  instructions  sometimes  provide  for 
postponement  of  presentation  for  acceptance  until  the  arrival 
of  the  shipment.  When  such  postponement  is  made,  the 
risks  obviously  fall  upon  the  seller,  solely. 

The  effect  of  the  letter  of  credit  is  to  reverse  the  incidence 
of  the  risk,  for  the  seller  is  then  afforded  an  opportunity  to 
market  his  bill  without  recourse  in  case  of  default  by  the 
buyer,  and  bears  only  the  risk  of  failure  on  the  part  of  the 
accepting  banker.  The  buyer,  on  the  other  hand,  is  bound  by 
the  terms  of  his  contract  for  the  letter  of  credit  to  pay  a  stated 
amount  of  money  at  a  future  time  without  regard  to  the  per- 
formance of  the  seller.  Since  the  bills  are  documented,  the 
buyer  is  assured  that  the  order  has  been  filled,  before  his 
liability  under  the  contract  becomes  binding;  but  no  guaranty 
is  given  him  of  the  sufficiency  of  the  goods  as  to  quantity  and 
quality;  his  only  recourse  is  to  bring  action,  on  the  basis  of 
the  contract  of  sale,  against  the  seller  in  his  own  market  and 
under  his  own  laws.  It  must,  of  course,  be  borne  in  mind  that 
the  acceptance  bill  drawn  under  the  letter  of  credit  does  not 
of  necessity  give  the  buyer  possession  of  the  goods  in  advance 
of  payment;  the  acceptance,  in  this  case,  is  a  banker's  accept- 
ance, and  the  shipping  documents  will  be  surrendered  to  the 
accepting  banker.  Further  negotiation  between  the  buyer 
and  the  bank  which  issued  the  letter  will  be  necessary  before 
these  shipping  documents  will  be  delivered  to  the  buyer  in 
advance  of  payment. 

The  second  method  of  permitting  deferred  payment  by  the 
importer  is  the  sale  of  goods  on  book  account,  with  provision 
made  for  periodic  settlements  of  the  balance  of  the  account- 
Goods  sold  on  book  account  are  consigned  directly  to  the 
buyer  who  obtains  them  upon  arrival.  Settlements  are  made 
at  predetermined  intervals  either  by  sight  draft  of  the  seller 
or  by  a  remittance  of  sight  or  cable  exchange  by  the  buyer. 
The  risks,  here,  are  obviously  placed  on  the  seller,  and  are  so 
great  that  this  method  is  not  much  used  in  foreign  trade. 

The  foregoing  discussion  of  the  character  of  the  bill  of  ex- 
change as  affected  by  the  terms  of  sale  may  be  summarized  as 
follows: 


270  FOREIGN  EXCHANGE 

A.  Terms  requiring  advance  payment  by  the  importer. 

(1)  Cash  with  order,  effected  by  a  remittance  of  de- 
mand exchange  by  the  buyer  at  the  time  of  plac- 
ing his  order. 

(2)  Cash  against  documents  at  the  Shipping  Point, 
effected  through  the  buyer's  agent  in  the  shipping 
market,  or  through  a  bank  credit  established  in 
that  market  in  favor  of  the  seller. 

(3)  Documentary  sight  draft  by  seller  on  buyer., 

B.  Payment  on  delivery  of  the  goods  to  the  importer. 

(1)  Documentary  sight  draft  of  seller  on  buyer  with 
presentation  postponed  until  inspection  of  the 
goods. 

(2)  Collection  through  a  letter  of  delegation  which 
permits  inspection  before  payment. 

(3)  Documentary  payment  draft  with  the  option  of 
prepayment. 

C.  Deferred  payment  by  the  importer. 

(1)  Documentary  acceptance  bill  with  or  without 
postponement  of  presentation  for  acceptance 
until  inspection  of  the  goods. 

(2)  Documentary  acceptance  bill  under  a  letter  of 
credit  with  a  surrender  of  the  shipping  documents 
against  a  trust  receipt  or  other  security. 

(3)  Sale  on  book  account,  payment  effected  by  sight 
draft  of  seller  or  by  remittance  from  buyer  at 
stated  intervals. 

62.  The  allocation  of  the  transportation  and  financing  costs. 
Buyer  and  seller  in  foreign  trade  must  agree  upon  a  method 
of  disposing  of  certain  costs  involved  in  every  transaction  in 
international  commerce.  For  purposes  of  discussion,  these 
costs  may  be  divided  into  two  groups :  (a)  the  costs  of  trans- 
portation and  of  insurance  against  the  risks  of  transportation; 
(6)  the  financing  costs,  including  bankers'  commissions,  stamp 
taxes,  and  interest.  It  may  be  laid  down  as  a  general  rule  at 
the  outset  that  all  costs  in  both  groups  will  fall  in  the  final 
instance  upon  the  buyer,  and  that,  if  any  of  them  are  borne  at 
first  hand  by  the  seller,  some  method  will  be  devised  by  which 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       271 

the  seller  will  reimburse  himself.  Our  interest  in  the  problem 
is  to  discover  in  what  ways  this  incidence  of  the  transporta- 
tion and  financing  costs  may  be  effected.  Let  us  consider 
first  the  various  items  included  in  the  cost  of  insuring  and 
transporting  the  goods. 

Whether  the  exporter  pays  any  of  the  transportation  costs 
for  the  account  of  the  buyer,  and,  if  so,  what  proportion  of 
them  he  pays,  is  determined  by  his  method  of  quoting  goods 
for  sale  in  foreign  markets.  It  serves  the  buyer's  convenience 
for  the  seller  to  assume  these  costs  and  include  them  in  the 
sale  price  of  his  goods;  this  enables  the  buyer  to  ascertain 
from  the  quoted  price  what  the  goods  will  cost  when  delivered, 
and  simplifies  his  problem  of  pricing  them  for  resale  in  his  own 
market.  Trade  practice  in  international  commerce  has  re- 
sulted in  various  forms  of  price  quotation  which  differ  with 
respect  to  the  proportion  of  these  costs  assumed  by  the  ex- 
porter and  included  in  the  sale  price;  arranged  in  the  order  of 
the  proportion  of  the  transportation  costs  which  they  allocate 
to  the  seller,  the  standard  quotations  are  the  following: 

F.O.B.  (named  point) Free  on  Board  (at  that  point). 

F.A.S.  Vessel  (named  port). .  .Free  Along  Side  (that  vessel). 
C.  &  F.  (named  foreign  f)ort) .  Cost  and  Freight  (to  that  port). 
C.I.F.  (named  foreign  port) .  .Cost,  Insurance  and  Freight  (to  that 

port). 

The  "Free  On  Board"  quotation  is  incomplete  without  a 
statement  of  the  point  at  which  the  seller's  duty  to  provide 
transportation  cost  ends  and  the  buyer's  begins.  Thus  an 
exporter  of  cement  who  offers  his  goods  for  sale  at  a  price  of 
$8  per  barrel,  F.O.B.  Factory,  undertakes  at  this  price  merely 
to  load  the  cement  on  the  cars,  and  places  upon  the  buyer  the 
duty  of  paying  all  rail  and  marine  freight,  and  insurance  costs. 
The  same  seller,  by  quoting  his  price  $8  per  barrel  F.O.B. 
Cars,  New  York,  undertakes  for  this  price  to  pay  rail  freight 
to  New  York  where  the  buyer  assumes  all  costs  upon  the  ar- 
rival of  the  goods  in  the  freight  cars.  Again,  the  quotation 
$8  per  barrel,  F.O.B.  Vessel,  New  York,  makes  a  still  different 
allocation  of  the  transportation  charges.     We  may  consider 


272  FOREIGN  EXCHANGE 

this  last  form  as  tj'pical  of  the  F.O.B.  quotation  in  foreign 
trade,  and  summarize  the  duties  of  the  two  parties  as  follows: ' 

A.  Seller  must 

(1)  Meet  all  costs  involved  in  preparing  the  goods  for 
shipment. 

(2)  Pay  all  rail  freight,  dock  and  lighterage  charges 
involved  in  placing  the  goods  aboard  the  out- 
bound vessel. 

(3)  Be  responsible  for  all  loss  or  damage  suffered  by 
the  goods  until  they  have  been  placed  on  board 
the  vessel. 

B.  Buyer  must 

(1)  Pay  marine  freight  to  destination  and  port  charge 
at  destination. 

(2)  Pay  insurance  costs. 

(3)  Be  responsible  for  all  loss  or  damage  suffered  by 
the  goods  after  they  have  been  placed  on  board. 

The  second  standard  form  of  quotation  is  Free  Along  Side 
Vessel  at  a  named  port  —  this  port  being,  in  most  instances, 
the  port  of  shipment  from  the  seller's  market.  The  difference 
between  this  quotation  and  the  F.O.B.  Vessel  is  not  great, 
consisting  principally  of  a  somewhat  different  distribution  of 
the  risk  of  loss  through  damage  to  the  goods.  When  the  ex- 
porter quotes  his  price  F.A.S.  Vessel,  the  distribution  of  costs 
between  the  two  parties  is  as  follows : 

A.  Seller  must 

(1)  Meet  all  costs  involved  in  preparing  the  goods  for 
shipment. 

(2)  Pay  all  rail  freight  charges,  all  storage  charges  at 
the  port,  and  all  dock  and  lighterage  charges 
required  to  place  the  goods  alongside  the  vessel 
on  the  wharf  or  in  lighters. 

(3)  Be  responsible  for  all  loss  or  damage  suffered  by 
the  goods  until  they  have  been  placed  in  position 
for  loading  on  the  vessel. 

^  In  this  summary  of  the  distribution  of  costs  made  by  the  different  forms 
of  quotation,  the  writer  follows  the  rule  published  by  the  National  Foreign 
Trade  Council. 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       £73 

B.  Buyer  must 

(1)  Pay  all  marine  freight  charges,  all  extraordinary 
loading  costs,  and  all  costs  of  unloading  at  the 
port  of  destination. 

(2)  Pay  all  insurance  costs. 

(3)  Be  responsible  for  all  loss  or  damage  after  the 
goods  have  been  placed  in  position  for  loading. 

The  third  form  of  quotation.  Cost  and  Freight  to  named 
foreign  port,  is  used  when  the  seller  includes  in  his  quoted 
price  more  of  the  transportation  costs  than  he  is  willing  to  pay 
when  using  the  F.O.B.  or  the  F.A.S.  forms.  The  C.  &  F.  quo- 
tation makes  the  following  distribution  of  costs : 

A.  Seller  must 

(1)  Meet  all  costs  involved  in  preparing  the  goods 
for  shipment. 

(2)  Pay  all  land  and  marine  freight  charges  to  the 
point  designated,  including  all  storage,  dock  and 
lighterage  costs  involved  in  loading  the  goods  at 
the  port  of  shipment. 

(3)  Be  responsible  for  all  loss  or  damage  until  the 
goods  have  been  delivered  alongside  the  ship  and 
a  "clean"  ocean  bill  of  lading —  that  is,  a  bill  of 
lading  certifying  the  receipt  of  the  goods  in  un- 
injured condition  —  has  been  obtained. 

B.  Buyer  must 

(1)  Pay  all  insurance  costs. 

(2)  Pay  all  charges  involved  in  taking  delivery  of  the 
goods  at  destination. 

(3)  Be  responsible  for  all  loss  or  damage  from  the 
time  the  clean  ocean  bill  of  lading  is  delivered  to 
his  agent  at  the  port  of  shipment. 

Our  exporter  of  cement,  who  quotes  his  goods  at  $8  per  barrel 
F.O.B.  Vessel,  New  York,  will  change  this  to  a  C.  &  F.  quota- 
tion by  ascertaining  the  marine  freight  costs  to  the  buyer's 
port,  and  adding  these  costs  to  his  price.  He  is  not,  however, 
compelled  actually  to  pay  the  marine  freight  in  advance;  it 
is  sufficient  for  him  to  subtract  the  freight  charges  from  his 
quoted  price  in  case  he  leaves  these  charges  to  be  paid  by  the 
buyer  upon  the  arrival  of  the  goods. 


274  FOREIGN  EXCHANGE 

The  C.I.F.  quotation  difTers  from  the  C.  &  F.  only  with 
respect  to  the  insurance  cost  and  the  responsibility  for  damage 
to  the  goods.  The  seller  uses  this  quotation  whenever  he 
wishes  to  offer  his  goods  for  sale  in  foreign  markets  at  prices 
which  will  relieve  the  buyers  of  all  incidental  costs  up  to  the 
time  when  delivery  is  made  by  the  ship  in  the  port  of  arrival. 
The  quotation  makes  the  following  distribution  of  costs: 

A.  Seller  must 

(1)  Meet  all  costs  involved  in  preparing  the  goods  for 
shipment. 

(2)  Pay  all  land  and  marine  freight  charges  to  the 
foreign  port  named,  together  with  all  costs  in- 
cidental to  loading  the  goods  upon  the  vessel  at 
the  shipping  point. 

(3)  Pay  the  costs  of  insuring  the  goods. 

(4)  Be  responsible  for  loss  or  damage  until  the  goods 
have  been  delivered  alongside  the  outbound  vessel 
and  a  clean  ocean  bill  of  lading  and  an  insurance 
policy  have  been  obtained. 

B.  Buyer  must 

(1)  Pay  all  charges  involved  in  taking  delivery  of  the 
goods  at  the  port  of  destination. 

(2)  Be  responsible  for  loss  or  damage  from  the  time 
the  clean  ocean  bill  of  lading  and  the  insurance 
policy  have  been  delivered  to  his  agent  at  the 
shipping  point. 

In  this  case,  again,  the  seller  is  allowed  the  option  of  pre- 
paying the  freight  or  subtracting  it  from  the  sale  price  of  his 
goods.  Assuming  that  the  buyer  of  cement  is  in  Buenos 
Aires,  that  the  marine  freight  from  New  York  to  that  city  is  $2 
per  barrel  and  the  marine  insurance  1/2  per  cent,  and,  finally, 
that  carload  lots  are  loading  in  New  York  from  the  freight 
cars  free  of  cost,  the  exporter  of  cement  will  change  his  price 
to  a  quotation  C.I.F.  Buenos  Aires  as  follows: 

Price  F.O.B.  Cars  New  York $8.00  per  bbl. 

Marine  freight  to  Buenos  Aires 2.00  per  bbl. 

Insurance  ($10  X  1/2%)    ^  per  bbl. 

Price  C.I.F.  Buenos  Aires  (carload  lots) . .  $10.05  per  bbl. 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       273 

It  will  be  noted  that  insurance  covers  the  value  of  the  goods 
as  enhanced  by  the  marine  freight  charges.  By  quoting  goods 
in  this  form,  it  is  obvious  that  the  exporter  passes  on  to  the 
buyer  all  transportation  and  insurance  costs  which  he  pays 
for  the  buyer's  account. 

We  should  take  account  of  one  other  method  of  quoting 
goods  for  sale  in  foreign  markets,  a  form  known  as  the  franco 
domicile  quotation.  A  seller  quotes  his  prices  in  this  form 
when  he  is  prepared  to  deliver  the  goods  at  the  buyer's  place 
of  business  free  of  all  charge  to  the  buyer.  This  means  that, 
in  addition  to  meeting  the  charges  placed  upon  him  by  the 
C.I.F.  quotation,  the  seller  must  pay  all  costs  involved  in 
taking  delivery  at  the  buyer's  port,  pay  the  customs  duties 
upon  the  goods,  and  all  costs  of  carrying  them  from  the  port 
to  the  buyer's  business  premises.  In  view  of  the  variable 
nature  of  customs  duties  and  of  the  seller's  difficulty  in  cal- 
culating the  costs  encountered  in  the  buyer's  port,  it  is  not 
strange  that  few  exporters  attempt  to  quote  their  goods  franco 
domicile.  It  sometimes  happens,  however,  that  the  exporter 
maintains  a  branch  office  or  an  agent  in  the  buyer's  city 
through  whom  delivery  can  be  made  and  adopts  the  franco 
domicile  quotation  because  it  serves  the  buyer's  convenience 
and  increases  the  seller's  competing  power. 

We  turn  now  to  the  financing  costs.  It  may  be  taken  for 
granted  that  these,  also,  will  fall  in  the  final  instance  upon  the 
buyer,  but  the  means  used  to  pass  them  on  to  him  are  very 
much  affected  by  the  method  of  payment  fixed  upon  by  the 
two  parties  when  concluding  the  terms  of  sale.  When  these 
terms  call  for  cash  with  order  or  cash  against  documents  at 
the  shipping  point,  the  buyer,  obviously,  pays  all  financing 
costs  in  advance.  Suppose,  for  example,  that  the  exporter  of 
cement,  quoting  his  price  $8  per  barrel  F.O.B.  Cars  New  York, 
concludes  a  sale  of  500  barrels  to  a  buyer  in  Buenos  Aires  on 
the  terms  cash  with  order.  In  confirming  his  order,  the  buyer 
must  place  in  the  seller's  hands  a  sight  draft  drawn  on  a  New 
York  bank  for  $4000,  paying  bankers'  commissions  required 
to  ol)tain  the  draft  in  his  own  market  and  assuming  the  loss  of 
interest  involved  in  making  this  advance  of  funds.    Similarly, 


876  FOREIGN  EXCHANGE 

if  the  terms  call  for  cash  against  documents  at  New  York,  the 
buyer  must  establish  a  bank  credit  of  $4000  for  the  benefit  of 
the  seller  in  New  York  payable  upon  delivery  of  the  railroad 
bill  of  lading.  (If  the  seller's  price  had  been  quoted  F.O.B. 
Vessel,  New  York,  the  documents  would  have  been  duplicate 
steamship  bills  of  lading.)  Here,  again,  the  buyer  must  bear 
all  financing  costs  in  advance  of  the  seller's  delivery  of  the 
goods.  Such  terms  as  these,  however,  are  exceptional  in  for- 
eign trade.  In  the  vast  majority  of  cases,  the  seller  will  sur- 
render his  goods  in  advance  of  payment  by  the  buyer,  and 
recover  the  amount  owing  him,  including  financing  costs, 
through  the  medium  of  a  bill  of  exchange.  When  payment  is 
effected  in  this  manner,  it  is  the  exporter's  practice  to  draw  his 
bill  of  exchange  in  such  form  that  it  will  have  a  value  at  the 
time  of  drawing  equal  to  the  invoice  price  of  his  goods;  this 
requires  the  inclusion  in  the  face  of  the  draft  of  a  "load"  or  an 
addition  to  compensate  the  financing  charges. 

The  costs  grouped  together  under  the  term  "financing 
costs"  fall  into  two  classes:  (a)  bankers'  commissions,  postage 
and  revenue  stamps;  (b)  loss  of  interest.  Conference  with  his 
banker  will  inform  the  exporter  as  to  the  amount  of  charge  of 
the  first  class  involved  in  the  transaction.  Bankers'  commis- 
sions for  handling  a  commercial  bill  vary  between  1/8  and  1/4 
percent  for  export  houses  of  good  standing  when  the  transac- 
tion involves  markets  closely  related  through  the  banking 
structure  of  the  world.  They  may  rise  as  high  as  two  per  cent 
when  unusual  costs  are  involved  in  their  negotiation,  or  when, 
for  any  reason,  the  banker  is  reluctant  to  handle  the  exporter's 
paper.  Revenue  stamps  are  affixed  in  the  country  where 
collection  is  made  and  their  amount  will  be  governed  by  the 
laws  of  that  country.  Postage  charges  are  not  always  passed 
on  to  the  exporter,  though  the  banker  will  waive  collection  of 
these  charges  only  in  those  cases  where  the  exporter's  business 
is  so  much  desired  that  the  banker  is  willing  to  bear  minor 
costs  himself.  In  computing  the  interest  loss,  it  may  be 
necessary  to  take  account  of  the  life  of  the  bill  and  also  of  the 
time  consumed  in  forwarding  it  to  the  point  of  collection; 
when  a  return  draft  is  called  for,  the  period  required  to  return 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       277 

the  proceeds  of  the  collection  must  be  added  in  computing 
the  interest  charge. 

In  explaining  the  methods  by  which  the  financing  costs  are 
imposed  on  the  buyer,  we  can  best  proceed  by  considering 
separately  two  different  conditions:  (a)  when  the  exporter's 
draft  is  drawn  in  the  buyer's  money  and  the  latter  discharges 
his  obligation  by  making  payment  in  this  money ;  (6)  when  the 
exporter's  draft  is  payable  in  his  own  money  or  in  the  money 
of  a  third  country.  We  shall  assume  at  the  outset,  in  con- 
sidering the  first  type  of  draft,  that  the  exporter  markets  his 
bill  at  the  time  of  drawing  —  that  is,  that  he  sells  it  to  his 
banker  for  its  present  value  in  cash.  To  bring  our  illustration 
more  nearly  into  conformity  with  the  realities,  let  us  suppose 
that  the  cement  exporter  quoting  a  price  of  $8  per  barrel, 
F.O.B.  Vessel,  New  York,  has  sold  500  barrels  to  an  English 
buyer  and  has  agreed  to  draw  a  documentary  acceptance  bill 
in  sterling  at  ninety  days'  sight  against  a  banker  in  England. 
Such  a  bill  can  be  sold  at  the  time  of  drawing;  the  banker's 
buying  price,  as  we  have  seen  in  a  former  chapter,  will  be 
calculated  from  the  prevailing  sight  rate  for  sterling  exchange, 
the  rate  of  interest  which  obtains  in  the  London  market,  and 
the  commission  and  stamp  charges,  as  follows: 

Sight  rate  of  the  day  of  drawing  (say) 4.85 

Subtract  charges 

Discount  (93/365  X  .05  X  4.85) . .    .0617 

Stamp  tax  (1/20%  X  4,85) 0024 

Commission  (1/8%  X  4.85) .006  .07 

Banker's  buying  rate 4.78 

This  computation  will  have  been  worked  out  by  the  banker 
before  an  offer  is  made  to  the  exporter  for  his  sterling  bill,  and 
the  result,  as  shown,  will  be  expressed  in  the  form  of  a  rate  of 
exchange  somewhat  lower  than  the  sterling  sight  rate.  The 
interest  and  other  financing  costs  are  concealed  in  the  dis- 
crepancy between  the  two  rates  of  exchange. 

In  possession  of  the  banker's  buying  price  for  his  sterling 
bill,  the  exporter  can  now  turn  the  invoice  value  of  his  goods 


278  FOREIGN  EXCHANGE 

into  sterling  by  dividing  its  amount  by  the  banker's  buying 
rate,  tlius: 

^000  H-  4.78=  £836  16s.  5d. 

This  reheves  the  exporter  of  all  financing  costs;  if  he  sells  his 
bill  at  the  rate  of  4,78  (there  is,  of  course,  the  risk  that  this 
rate  may  have  fallen  before  the  exporter  can  conclude  his 
transaction)  he  obviously  recovers  the  $4000  which  is  the 
present  value  of  his  goods.  The  importer  pays  interest  and 
other  financing  costs  when  he  redeems  the  sterling  long  bill  at 
maturity. 

By  this  simple  method,  exporters  pass  the  financing  costs 
on  to  the  buyers  when  they  draw  in  the  buyer's  money  and 
market  their  bills.  It  is  also  possible  to  use  the  same  method 
when  these  bills  are  not  sold,  but  placed  with  the  bankers  for 
collection,  but  it  is  highly  improbable  that  the  seller  will  con- 
sent to  recover  financing  costs  in  this  way  when  receiving 
payment  through  collection  bills.  In  the  case  just  considered, 
the  interest  charge  paid  by  the  buyer  is  not  received  by  the 
seller  of  the  goods,  but  by  that  money-lender  in  the  discount 
market  who  buys  the  bill  of  exchange  after  acceptance. 
\Mien  collection  bills  are  employed,  however,  this  interest 
payment  goes  to  the  seller  by  reason  of  the  fact  that  this  party 
waits  for  his  returns  until  the  maturity  of  the  bill,  at  which 
time  he  receives  the  buyer's  payment  in  full  with  the  subtrac- 
tion of  bankers'  commissions  and  stamp  charges.  To  apply 
the  same  method  to  the  drawing  of  collection  bills,  therefore, 
w411  require  the  seller  to  make  an  advance  of  funds  at  the  rate 
of  interest  obtaining  in  a  foreign  acceptance  market,  whereas 
the  real  cost  of  making  this  advance  will  be  determined  by 
the  rate  of  interest  applicable  to  commercial  loans  in  his  own 
market.  For  this  reason,  a  somewhat  different  method  of 
computing  the  interest  charge  is  adopted  in  connection  with 
bills  placed  with  the  bankers  for  collection.  The  seller  makes 
out  his  invoice  as  before,  and  adds  as  a  separate  and  distin- 
guishable charge  against  the  buyer,  interest  at  the  commercial 
rate  in  the  seller's  market,  plus  bankers'  commissions  and 
stamp  charges.     The  bankers'  commissions  will  be  a  per- 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       279 

centage  of  the  face  of  the  draft,  not  of  the  net  sale  price;  it  is 
the  practice  to  compute  the  interest  charge,  also,  not  on  the 
net  sale  price,  but  on  the  face  of  the  draft.  The  following 
example  will  illustrate  the  method.^ 

500  bbls.  of  cement  ®  $8.00 $4000.00 

Interest  (90/365  X  .06  X  $4073.31) 61.10 

Commission  (1/4  per  cent  X  $4073.31) "      10.18 

Stamp  tax  (1/20  per  cent  X  $4073.31) 2.03 

Invoice  total $4073.31 

The  invoice  total  may  be  turned  into  sterling  at  the  sight  rate 
obtaining  in  New  York  at  the  time  of  drawing,  or  at  a  nominal 
rate,  previously  agreed  upon  between  buyer  and  seller,  ap- 
proximating the  sight  rate.  The  long  sterling  rate,  it  must  be 
understood,  cannot  be  used,  since  it  contains  an  allowance 
for  interest;  if  used,  therefore,  to  convert  the  invoice  total 
which  also  includes  an  interest  charge,  the  buyer  would  be 
charged  twice  for  the  interest.  Assuming  that  the  exporter 
will  draw  at  the  rate  of  4.85,  his  bill  will  call  for  the  payment 
■of  £839  17s.  2d.  (4073.31  ^  4.85).  In  this  case,  the  risk  of 
exchange  to  the  seller  is  greater  than  when  he  markets  his 
draft;  the  proceeds  will  be  turned  over  to  him  at  the  time  of 
the  collection  and  at  the  rate  of  exchange  obtaining  at  that 
time;  this  rate  may  be  either  higher  or  lower  than  4.85,  the 
rate  employed  in  converting  his  invoice  into  sterling. 

We  come  now  to  the  method  employed  to  shift  the  financing 
costs  to  the  buyer  when  the  exporter's  bill  calls  for  a  return 
draft  in  his  own  money  or  in  the  money  of  a  third  country. 
In  this  case,  the  waiting  period  for  which  interest  will  be  de- 

^  In  the  example  before  us,  interest  is  computed  at  6  per  cent  per  annum  for 
three  months,  which  is  equivalent  to  l/2  per  cent  per  month  or  1  l/2  per  cent 
of  the  invoice  total.  The  commission  is  assumed  to  be  1/4  per  cent,  and  the 
stamp  tax  1/20  per  cent.  The  sum  of  these  charges  (interest  1  1/2  per  cent, 
commission  1/4  per  cent,  stamps  1/20  per  ccnt^  is  1  4/5  per  cent  which  must 
be  figured  on  the  invoice  total.  Four  thousand  dollars,  the  net  price,  is,  there- 
fore, 98  1/5  per  cent  of  the  total.  Given  this  information,  to  find  the  total 
of  the  invoice  is  a  simple  problem  in  arithmetic: 

$4000  is  98  1/.5  per  cent  of  the  total; 

1  per  cent  of  the  total  is  $40.7331; 

100  per  cent  of  the  total  is  $4073.31. 


280  FOREIGN  EXCHANGE 

manded  by  the  exporter  covers  the  life  of  his  bill  plus  the  mail 
time  to  the  buyer's  market  and  return,  since  payment  is  not 
consummated  until  the  return  draft  is  in  the  seller's  hands. 
In  the  foreign  trade  practice  of  the  United  States,  these  re- 
turn drafts  are  of  four  varieties:  (a)  drawn  in  dollars  at  sight; 
(b)  in  dollars  at  ninety  days  after  sight;  (c)  in  sterling  at  sight; 
(d)  in  sterling  at  ninety  days  after  sight.  In  each  case,  the 
seller's  task  will  be  to  draw  the  bill  in  such  form  that  the  re- 
turn draft  will  have  a  value  on  arrival  equal  to  the  total  of  his 
invoice,  including  interest  and  other  financing  costs;  this  will 
give  the  bill  a  value  at  the  time  of  drawing  equal  to  the  sale 
price  of  the  goods. 

Under  normal  conditions,  return  drafts  are  not  used  in  our 
trade  with  Europe,  but  are  frequently  employed  in  South 
American  trade.  ^  Accordingly,  we  must  vary  our  illustration 
in  order  to  bring  it  into  conformity  with  trade  practices.  Sup- 
pose, then,  that  the  exporter  of  cement  has  sold  500  barrels  at 
$8  per  barrel,  F.O.B.  Vessel,  New  York,  to  a  buyer  in  Brazil 
and  is  to  draw  at  thirty  days'  sight  for  a  return  draft  in  dollar 
sight  exchange;  the  mail  time  both  ways  may  be  assumed  to 
be  sixty  days;  the  rate  of  interest  in  New  York,  6  per  cent; 
the  bankers'  commission  which  the  exporter  pays,  1/2  per  cent. 
The  exporter's  bill  of  charges  against  the  buyer  would  appear 
as  follows: 

500  bbls.  of  cement  @  $8.00 $4000. 

Interest  (90/365  X  .06  X  4081.63) 61.22 

Commission  (1/2  oer  cent  X  4081.63) 20.41 

$4081.63 

He  will  draw  a  bill  reading  as  follows: 

Thirty  days  after  sight  pay  to  the  order  of  the  First  Commercial 
Bank  $4081.63.  Payable  in  sight  drafts  at  the  bank's  drawing  rate 
on  New  York  on  the  date  of  payment. 

The  return  draft  will  be  worth  its  face  upon  arrival  and  will, 
therefore,  reimburse  the  exporter  for  all  financing  costs  in 
'  This  subject  has  ah-eady  been  treated  (see  pages  194-202).  It  is  included 
in  this  place  for  the  sake  of  giving  our  discussion  of  the  trade  practices  the 
merit  of  completeness. 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       281 

addition  to  paying  him  the  vahie  of  his  goods.  If  a  return 
draft  in  dollars  drawn  at  ninety  days'  sight  is  called  for,  its 
amount  should  be  such  that  it  will  sell  for  $4081.63  upon  ar- 
rival. The  cost  to  the  Brazilian  buyer  of  a  dollar  sight  draft 
for  $4081.63,  will  be  the  same  as  the  cost  of  a  ninety-day  dol- 
lar bill  which  will  sell  for  $4081.63,  upon  arrival  in  New  York;* 
the  long  bill,  however,  gives  the  buyer  a  valuable  opportmiity 
to  postpone  payment  and  obtain  an  additional  period  of  pay- 
ment. The  exact  amount  by  which  the  dollar  long  bill  must 
exceed  the  sight  draft  will,  of  course,  be  determined  by  the 
discount  rate  in  the  New  York  market  for  bankers'  accept- 
ance of  ninety  days'  usance. 

When  the  return  draft  is  to  be  sterHng  exchange,  its  amount 
should  be  determined  by  the  same  principle  of  giving  it  a 
value  of  $4081.63  upon  arrival.  In  this  case,  how^ever,  the 
seller  can,  at  best,  hope  only  to  receive  approximately  the 
required  amount  of  dollars  when  selling  the  return  draft,  since 
its  value  will  be  determined  by  the  rate  of  exchange  at  the 
time  of  arrival  —  ninety  days  after  drawing,  in  our  illustra- 
tion. This  obviously  throws  his  transaction  open  to  risk  of 
exchange.  If  the  return  draft  is  to  be  sterling  sight,  he  may 
employ  the  sterling  sight  rate  obtaining  at  the  time  of  drawing 
in  order  to  convert  the  invoice  total  into  pounds;  but  it  is 
obvious  that  the  rate  of  exchange  may  either  rise  or  fall  before 
the  return  draft  is  placed  in  his  hands,  and  that  his  receipts 
may  be  affected,  correspondingly.  In  like  manner,  when  a 
return  draft  of  long  sterling  is  called  for,  he  may  convert  the 
invoice  total  into  pounds  at  the  long  rate  obtaining  at  the 
time  of  drawing;  but,  again,  the  transaction  will  be  open  to 
risk  of  exchange.  We  shall  consider  the  means  the  exporter 
may  employ  to  guard  against  this  risk  of  exchange  in  the  sec- 
tion immediately  following.  | 

In  this  summary  of  the  methods  of  disposing  of  the  financ- 
ing costs,  we  should  take  account  of  one  other  method  fre- 
quently employed  in  connection  with  exporter's  bill  calling 
for  return  drafts.    Perhaps  the  majority  of  such  bills  bear  the 

^  This  is  tnie  berause  the  dollar  loiif;  rate  in  Hrazil  is  lower  than  the  dollar 
sight  rale  by  an  auiouut  yoverucd  by  llii;  rale  of  diacouiil  iu  New  York. 


282  FOREIGN  EXCHANGE 

interest  clause;  the  exporter  draws  for  the  sale  price  of  his 
goods  plus  bankers'  commission  —  $-40120  in  the  illustration 
we  are  using —  and  writes  upon  the  face  of  the  diaft: 

Payable  at  the  bank's  drawing  rate  on  (the  appropriate  city  oon- 
forniing  to  the  nature  of  the  return  draft)  on  tlie  day  of  payment, 
with  interest  at  ...  .  per  cent  from  the  date  of  drawing  to  the  ap- 
proximate date  of  arrival  of  funds  in  New  York. 

This  is  the  only  type  of  bill  which  places  the  interest  charge 
expli:;itly  upon  the  buyer.  The  interest  clause  is  not  used 
except  where  return  drafts  are  called  for. 

63.  How  the  risk  of  exchange  is  handled.  At  various 
points  in  the  preceding  discussion,  reference  has  been  made 
to  the  risk  of  exchange;  we  shall  now  proceed  to  examine  the 
methods  by  which  this  risk  may  be  avoided  or  minimized. 
Risk  of  exchange  is  borne  by  buyer  and  seller  in  international 
commerce  whenever  either  party  assumes  costs  in  considera- 
tion of  a  return  whose  amount  will  be  affected  by  a  future  rate 
of  exchange,  or  contracts  to  buy  goods  whose  cost  will  be 
affected  by  a  future  rate.  The  risk  is  inherent  in  the  fact 
that,  when  effecting  payment  in  foreign  trade,  either  buyer  or 
seller  or  both  must  convert  costs  or  receipts  into  a  foreign 
money.  Unless  the  terms  of  payment  call  for  cash  with  order 
or  cash  against  documents  at  the  shipping  point,  this  conver- 
sion into  a  foreign  money  must  be  made  at  a  future  date  when 
the  condition  of  the  exchange  market  cannot  be  known  with 
certainty.  The  risk  may  fall  solely  on  the  seller,  as  when  he 
prices  his  goods  in  a  foreign  money  and  draws  a  bill  payable  in 
this  money  at  a  future  date.  Or  it  may  fall  solely  upon  the 
buyer,  as  when  he  buys  goods  priced  m  a  foreign  money  and 
agrees  to  buy  foreign  exchange  for  this  amount  at  a  later  date. 
Or,  it  may  fall  upon  both  parties,  as  when  the  exporter  draws 
under  a  sterling  letter  of  credit,  having  quoted  his  price  in 
advance  of  drawing;  and  the  buyer,  having  accepted  the  goods 
thus  priced,  is  bound  by  his  contract  with  the  bank  issuing  the 
letter  to  cover  the  exporter's  bills  in  sterling  at  a  later  date. 

Certain  rough-and-ready  methods  are  available  to  business 
men  whose  foreign  transactions  are  of  no  considerable  im- 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       283 

portance  whereby  the  risk  of  exchange  may  be  avoided.  Ex- 
porters, for  example,  may  price  their  goods  in  their  own  money 
and  refuse  to  convert  these  prices.  This  will  very  seriously 
restrict  their  choice  of  terms  of  payment,  since  they  cannot 
agree  to  draw  in  the  money  of  the  buyer  nor  accept  letters  of 
credit  issued  against  foreign  banks;  practically  the  only  means 
of  payment  available  to  them  when  pursuing  this  policy  is  a 
remittance  of  dollar  exchange  by  the  buyer  either  in  advance 
of  delivery  or  subsequent  thereto.  Importers,  on  the  other 
hand,  may  insist  on  price  quotations  in  their  own  money  and 
accede  to  no  other  terms  of  payment  than  bills  drawn  in  that 
money;  this  policy,  also,  is  incompatible  with  wide  extension 
of  foreign  transactions.  Again,  both  exporters  and  importers 
may  adopt  conversion  tables  which  translate  dollar  prices  into 
foreign  moneys,  and  vice  versa,  at  fixed  rates  sufficiently  below 
or  above  the  actual  rates  to  allow  for  any  probable  fluctuation 
of  the  market.  Generally  speaking,  however,  foreign  mer- 
chants cannot  conduct  transactions  of  any  considerable  pro- 
portions without  incurring  risk  of  exchange.  When  this  is 
the  case,  they  may  guard  against  the  risk  by  carrying  on 
"hedge"  transactions  in  the  exchange  market. 

The  hedge  is  a  deal  in  a  future  contract  for  the  purchase  or 
sale  of  foreign  bills;  its  purpose  is  to  inform  the  merchant  of 
the  rate  at  which  he  can  buy  exchange  needed  at  a  future  date, 
or  can  sell  exchange  which  he  will  be  empowered  at  a  future 
date  to  draw.  On  the  side  of  the  exporter,  a  typical  hedge 
transaction  would  be  somewhat  as  follows:  An  exporter  of 
bacon,  let  us  say,  has  received  in  May  an  inquiry  from  an 
English  buyer  for  a  quotation  in  sterling  upon  a  shipment  to 
1)6  made  in  August  and  financed  by  a  ninety-day  sterling 
draft.  Before  quoting  his  price,  the  exporter  may  inquire  of 
his  banker  what  rate  he  will  offer  for  a  sterling  long  draft  to  b( 
delivered  in  August,  thus  informing  himself  in  advance  of  the 
conditions  under  which  he  can  convert  his  bill  for  the  bacon 
into  dollars  and  cents.  He  can  then  adjust  his  price  so  as  to 
insure  a  profit  and,  if  the  sale  is  made,  immediately  place  in 
the  banker's  hands  a  contract  to  deliver  a  given  amount  of 
sterling  at  the  rate  of  exchange  agreed  upon.    A  hedge  trans- 


284  FOREIGN  EXCHANGE 

action  for  an  importer  would  consist  in  the  signinf^  of  a  con- 
tract with  a  banker  to  buy  a  stated  amount  of  foreign  ex- 
change at  a  stated  price  upon  a  given  date.  For  example,  an 
American  buyer  of  English  cutlery  may  place  an  order  for  a 
shiijment  of  goods  priced  in  sterling  and  agree  to  make  pay- 
ment by  remittance  of  sterling  demand  drafts  upon  arrival 
of  the  goods.  While  he  has  the  order  under  consideration  and 
is  calculating  its  profitableness,  it  will  give  accuracy  to  his 
calculations  if  he  can  foretell  at  what  rate  of  exchange  the 
sterling  demand  drafts  w^ill  be  sold  him  on  the  day  of  payment. 
Accordingly,  he  inquires  of  his  bankers  at  what  rate  they  will 
contract  to  supply  the  needed  amount  of  sterling  on  the  given 
day,  and,  having  placed  his  order,  signs  the  future  contract 
which  assures  him  possession  of  the  exchange  at  the  prede- 
termined rate. 

It  must  not  be  understood  that  the  bankers  who  deal  in 
these  future  contracts  are  always  speculating  with  the  course 
of  the  exchange  rates.  In  most  cases,  they  will  cover  one 
type  of  future  contract  with  the  other  and  take  their  profit 
from  the  slight  difference  between  the  rates  at  which  they 
agree  to  buy  and  sell.  In  others,  they  will  be  contracting 
to  buy  and  sell  future  exchange  because  they  have  already 
sold  or  bought  other  bills  payable  in  the  same  money  on  future 
days,  and  wish  to  foretell  the  rates  at  which  they  will  be  able 
to  realize  upon  their  transactions.  For  example,  the  banker 
who  contracted  to  sell  the  future  exchange  to  the  importer  of 
cutlery  may  have  bought  commercial  long-payment  bills 
which  will  mature  at  about  the  same  date  as  that  on  which  the 
sterling  demand  drafts  will  be  delivered  to  the  importer;  his 
contract  with  the  importer  is  merely  the  method  by  which  the 
banker  discovers  in  advance  the  terms  upon  which  he  can 
employ  the  sterling  credit  which  accrues  from  the  collection 
of  the  payment  bills.  Similarly,  the  banker  who  contracts 
to  buy  the  exporter's  sterling  draft  may  have  drawn  finance 
bills  to  mature  on  the  same  date  and  wishes  to  secure  cover  for 
these  bills  at  a  predetermined  rate.  Bankers  make  use  of 
these  futures  in  sufficient  numbers  to  create  in  a  smoothly 
functioning  exchange  market  opportunities  for  business  men 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       285 

engaged  in  foreign  trade  to  hedge  against  the  risk  of  exchange 
in  all  their  transactions.  Business  houses  of  long  standing 
are,  as  a  rule,  ready  to  reduce  the  speculative  element  in  their 
trade  to  a  minimum  by  availing  themselves  of  these  oppor- 
tunities to  hedge. 

64.  Economic  functions  of  commercial  bills.  Our  study  of 
commercial  bills  of  exchange  has  made  it  clear  that  such  a 
bill,  as  a  servant  of  the  world's  business  men,  may  perform 
one  or  both  of  two  distinct  economic  functions:  (a)  it  may 
facilitate  the  collection  of  money  owing  in  a  foreign  country, 
discharging  what  we  may  call  the  "function  of  collection"; 
(6)  it  may  enable  the  business  men  to  call  to  their  aid  financial 
resources  other  than  their  own  when  carrying  through  a  trans- 
action; this  we  may  call  a  "financing  function."  Not  all  bills 
of  exchange  are  of  such  a  nature  as  to  perform  both  of  these 
services  together;  some  act  as  a  collection  agency  only;  others, 
as  a  collection  and  as  a  financing  agency;  none  as  a  financing 
agency  alone.  The  distinction  in  form  between  commercial 
bills  which  determines  their  fitness  to  perform  these  functions 
is  somewhat  difiicult  to  confine  in  a  simple  formula,  but  the 
following  sentence  is  an  attempt  to  express  it  so:  When  com- 
mercial bills  of  exchange  are  payable  on  presentation  (sight  and 
demand  drafts  of  all  kinds),  they  perform  the  collection  function 
only;  when  they  embrace  a  time  element  (long  bills  of  all  kinds), 
they  perform  both  the  collection  and  the  financing  function,  unless 
they  are  handled  by  the  bankers  for  collection  alone. 

It  is  the  purpose  of  the  following  sections  to  analyze  these 
economic  services  of  bills  of  exchange  in  so  far  as  they  relate 
to  commercial  transactions  between  nations. 

65.  The  collection  function  of  bills  of  exchange.  When  a 
sight  draft  is  used  to  effect  payment  in  a  commercial  transac- 
tion, whether  it  is  drawn  by  the  exporter  and  redeemed  by  the 
importer,  or  bought  by  the  importer  and  cashed  by  the  ex- 
porter, the  bill  of  exchange  has  no  power  to  increase  the  finan- 
cial resources  of  the  two  parties.  The  draft  merely  transfers 
funds  from  one  to  the  other,  causing  an  outgo  and  an  income 
which,  disregarding  fluctuations  in  the  rates  of  exchange,  are 
equal  to  each  other,  and  adding  nothing  to  the  combined  re- 


286  FOREIGN  EXCHANGE 

sources  of  lioth  buyer  aud  seller.  To  state  the  same  truth  in 
a  dili'erent  form,  the  i)urchashig  power  of  an  importer  over 
goods  in  a  foreign  eountry  —  the  base  upon  which  he  conducts 
his  business  —  is  limited  to  his  own  cash  resources  when  a 
sight  draft  is  used  as  a  mode  of  payment,  just  as  really  as  if  he 
had  expended  money  directly  in  the  purchase  of  the  goods. 
This  statement  does  not  imply  that  neither  exporter  nor  im- 
porter may  call  upon  the  banks  for  aid;  both  parties  may  rely 
upon  loans  for  a  large  part  of  the  funds  with  which  their  trans- 
actions are  financed.  But  this  aid  is  not  received  through  the 
instrumentality  of  the  sight  draft,  since  the  draft  accomplishes 
nothing  more  than  collection  from  the  buyer  of  the  amount 
owed  the  seller. 

Within  its  sphere  thus  limited,  however,  the  sight  draft 
plays  no  insignificant  role  in  facilitating  the  international  com- 
merce of  the  world.  It  promotes  a  continuous  flow  of  commod- 
ities from  one  country  to  another  by  removing  obstacles  which 
would  otherwise  stand  in  the  way  of  the  development  of  inter- 
national trade  relations,  obstacles  created  by  the  distance 
which  separates  the  two  markets,  the  difficulties  of  dealing  in 
two  distinct  systems  of  coinage,  and  the  diversity  of  legal  and 
customary  procedure  which  make  mutual  understanding  and 
confidence  difficult  to  attain.  Its  aid  enables  the  merchant 
to  make  and  receive  payments  in  the  foreign,  with  the  same 
ease  as  in  the  domestic,  department  of  his  business;  through 
its  agency,  the  financial  side  of  international  commerce  is 
resolved  for  both  buyer  and  seller  into  a  simple  negotiation 
with  a  near-by  banker  and  in  a  familiar  medium  of  exchange, 
throwing  upon  the  banks  the  task  of  bridging  the  distance 
between  the  two  markets  and  of  translating  one  coinage  sys- 
tem into  the  other.  In  discharging  its  function  as  an  agency 
of  collection,  the  bill  of  exchange  increases  the  convenience 
and  the  confidence  with  which  sales  of  goods  can  be  made  in 
distant  markets,  and  serves  to  unite  the  nations  of  the  world 
into  closer  economic  union. 

Furthermore,  in  performing  the  collection  function,  bills 
of  exchange  reduce  the  cost  of  carrying  on  trade  between 
nations  and  thus  make  in  the  direction  of  a  cheaper  and  more 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       287 

plentiful  supply  of  goods  in  all  the  markets  of  the  world. 
Commerce  implies  a  double  transfer  of  wealth,  the  transfer  of 
goods  from  seller  to  buyer  and  of  other  goods,  or  money,  from 
buyer  to  seller.  Each  transfer  has  its  own  peculiar  costs,  im- 
portant among  which,  in  international  commerce,  is  the  cost 
of  physical  transportation ;  and  these  costs  restrict  exchanges 
and  operate  to  increase  the  scarcity  of  goods.  But  for  the 
foreign  bill  of  exchange,  both  of  these  transfers  of  physical 
wealth  would  be  a  necessary  part  of  almost  every  international 
transaction;  the  total  cost  of  making  the  trade  would  then  be 
the  sum  of  all  the  costs  involved  in  both  transfers,  and  goods 
would  have  to  sell  at  a  price  high  enough  to  recover  this  total 
cost.  As  we  have  seen,  the  transportation  of  gold  from  one 
nation  to  another  is  an  expensive  operation,  necessitating  an 
expenditure  of  labor  in  handling  the  gold  at  both  ends,  a 
burden  on  the  shipping  facilities  of  the  world,  and  a  period  of 
many  days'  waiting  during  which  the  gold  is  available  for  the 
purpose  of  neither  buyer  nor  seller.  If  each  importation  re- 
quired the  exportation  of  an  equivalent  amount  of  money — ■ 
and  this  would  be  largely  true  in  the  absence  of  bills  of  ex- 
change —  shipments  of  gold  in  amounts  large  and  small  in 
and  out  of  the  country  would  be  a  daily  recurring  necessity, 
involving  in  the  aggregate  an  enormous  cost  in  labor  and  wait- 
ing, a  cost  which  would  burden  and  restrict  the  exchange  of 
commodities  between  the  nations.  The  employment  of  bills 
of  exchange  as  collection  agencies  places  the  duty  of  shipping 
gold  upon  the  bankers  who  act  as  middlemen  for  buyer  and 
seller,  and  this  permits  the  impounding  into  large  aggregates 
of  the  countless  number  of  small  sums  which  importers  of  each 
market  owe  their  foreign  creditors;  hence,  credits  may  be  off- 
set against  debits  and  only  the  balance  which  remains  payable 
from  the  aggregate  trade  of  an  extended  period  need  be  trans- 
ported across  the  seas.  By  reducing  to  a  small  fraction  the 
gold  shipments  which  would  otherwise  be  necessary,  labor  and 
capital  are  released  for  the  performance  of  other  wealth-pro- 
ducing services,  and  the  business  world  is  relieved  of  the 
major  proportion  of  the  loss  of  time  involved  in  the  transpor- 
tation of  gold  between  distant  markets.     All  labor-saving 


988  FOREIGN  EXCHANGE 

devices  have  as  a  necessary  consequence  an  increased  plenty 
of  floods  and  services  available  for  the  satisfaction  of  human 
wants,  and  this  important  service  the  bill  of  exchange  renders 
as  a  phase  of  its  function  as  an  agency  of  collection. 

Bills  of  exchange  resolve  the  exports  of  a  nation  into  a  fund 
of  international  purchasing  power  available  for  the  uses  of 
any  individual  within  the  exporting  country  who  desires  to 
buy  of  the  goods  and  services  of  foreign  peoples.  The  na- 
tion's foreign  sales  bestow  upon  its  people  the  power  to  create 
drafts  payable  in  other  countries;  this  power  is  passed  to  the 
banks,  merged  in  a  common  fund,  and  apportioned  in  suitable 
amounts  to  importers  who  need  bujang  power  which  has  cur- 
rency abroad.  Thus,  the  insuperable  obstacles  of  barter  are 
obviated  without  destroying  that  foundation  upon  which  all 
trade  must  rest.  Considered  as  a  whole,  the  nation  still  bar- 
ters exports  for  imports ;  but  mthin  the  nation,  the  exporters 
and  importers,  employing  bills  of  exchange  as  agencies  of 
collection,  receive  payment  for  their  sales  and  make  payment 
for  their  purchases  in  domestic  money.  Exporters  are  free  to 
seek  out  the  most  profitable  foreign  markets  without  regard 
to  the  ability  of  these  markets  to  supply  the  imports  desired 
by  the  exporter's  country;  importers,  in  turn,  are  free  to  buy 
what  and  where  they  please,  regardless  of  the  suitability  of 
their  country's  exports  to  meet  the  needs  of  the  markets  in 
which  they  buy. 

These  many  services  of  the  bill  of  exchange,  functioning  as 
an  agency  of  collection,  are  most  in  evidence  in  abnormal 
times  when  the  exchange  markets  of  the  world  have  broken 
down  and  the  world's  traders  are  denied  the  aid  upon  which 
they  have  come  to  rely.  The  trade  of  the  United  States  with 
Australia  is  customarily  financed  by  bills  which  bear  the 
Colonial  Clause;  that  is,  bills  payable  in  London  by  remit- 
tances of  sterling  exchange.  Australian  merchants  sell  wool 
and  grain  to  England,  pass  their  sterling  bills  to  Australian 
banks,  and  thus  supply  their  banks  with  London  credits 
against  which  to  draw  bills  for  the  use  of  other  Australian 
merchants.  Americans  sell  farm  machinery  and  other  prod- 
ucts to  the  people  of  Australia,  draw  against  the  buyers  bills 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       289 

payable  in  sterling,  and  the  buyers  cover  these  bills  by  utilizing 
the  sterling  credits  created  Vjy  Australian  exporters  of  wool  and 
grain.  In  normal  times,  this  triangular  use  of  bills  of  exchange 
admirably  serves  the  needs  of  the  business  men  in  both  mar- 
kets. But  the  breakdown  of  the  exchange  market  which  devel- 
oped toward  the  end  of  the  year  1920  brought  this  practice  to 
an  abrupt  halt ;  the  collapse  of  the  wool  market  made  it  impos- 
sible for  Australia  to  establish  a  sufficient  credit  in  London, 
and  Australian  importers  found  themselves  unable  to  pur- 
chase sterling  drafts.  Firms  in  America  which  had  sold  farm 
machinery  to  Australia  discovered  that  there  was  no  way  of 
collecting  the  money  owing  them;  the  importer  in  Australia, 
though  solvent  and  willing  and  anxious  to  make  payment, 
could  find  no  bank  in  his  market  which  would  take  his  money 
in  exchange  for  sterling  bills;  and  the  American  exporter's 
banker  was  forced  to  refuse  to  buy  bills  which  could  not  be 
covered  in  London.  The  bill  of  exchange  had  temporarily 
ceased  to  function  as  an  agency  of  collection.  Other  mar- 
kets, notably  South  American,  were  similarly  afTected  at  the 
same  time;  American  exporters  found  that  the  alternative  to 
the  bill  of  exchange  —  direct  barter  of  exports  for  imports  — 
was  so  expensive  and  cumbersome  as  to  prove  destructive  of 
international  trade. 

66.  The  financing  function  of  bills  of  exchange.  All  com- 
mercial bills  of  exchange,  whatever  their  form,  act  as  agencies 
of  collection,  discharging  the  services  discussed  in  the  pre- 
ceding paragraphs.  Those  bills  which  provide  for  the  receipt 
of  money  by  the  exporter  in  advance  of  payment  by  the  im- 
porter —  that  is,  all  commercial  long  bills  except  those  taken 
by  the  bankers  for  collection  only  —  render  in  addition  the 
important  service  of  supplying  from  outside  sources  funds  to 
facilitate  the  transaction  between  exporter  and  importer. 

International  trade  is  a  time-consuming  process;  if  buyer 
and  seller  provide  from  their  own  financial  resources  the 
means  for  carrying  through  each  commercial  transaction,  one 
of  these  individuals  must  make  an  advance  of  funds  in  con- 
sideration of  a  deferred  return.  The  burden  of  this  advance 
may  fall  upon  buyer  or  seller  according  to  agreement;  upon 


290  FOREIGN  EXCHANGE 

buyer,  if  cash  is  paid  for  floods  upon  delivery  and  the  buyer 
looLs  to  a  subsequent  sale  to  recover  the  amount  advanced; 
upon  seller,  if  goods  are  sold  on  credit,  the  seller  parting  with 
their  value  and  expecting  a  return  at  some  future  date.  Only 
a  limited  trade  could  be  carried  on  if  the  burden  of  the  ad- 
vance nuist  be  borne  by  one  of  the  two  merchants,  since, 
forced  to  rely  upon  their  own  limited  resources  to  tide  them 
over  a  period  of  waiting,  they  would  in  many  cases  be  com- 
pelled to  halt  further  operations  until  a  preceding  transaction 
had  been  liquidated.  The  traders,  it  is  true,  might  borrow 
from  the  banks  upon  the  basis  of  their  general  credit,  but,  in 
the  absence  of  bills  of  exchange,  it  would  be  difficult  to  devise 
a  method  of  borrowing  which  would  base  the  loan  upon  the 
security  of  the  goods  changing  hands,  and  thus  make  the 
foreign  commercial  transaction  self-liquidating. 

To  finance  a  transaction  means  to  advance  the  means  of 
covering  its  costs  in  expectation  of  repayment  at  some  future 
date.  In  the  economic  structure  of  modern  society,  a  distinct 
group  of  business  men  has  developed  whose  primary  function 
it  is  to  supply  the  money  or  credit  needed  to  finance  mercan- 
tile transactions,  to  bear  the  burden  of  waiting  for  a  deferred 
return  in  consideration  of  a  reward  in  the  form  of  interest 
upon  the  funds  advanced.  The  commercial  long  bill  enables 
traders  in  international  commerce  to  avail  themselves  of  the 
financing  function  of  the  bankers;  it  relieves  the  importer  of 
the  necessity  of  paying  for  his  purchases  cash  on  delivery, 
allows  him  a  period  of  time  in  which  to  consummate  the  trans- 
action for  which  the  importation  was  made,  so  that  the  resale 
of  the  goods  may  provide  the  funds  required  to  discharge 
his  obligation  to  the  foreign  exporter.  Through  the  aid  of 
commercial  long  bills,  importations  may  be  made  to  a  large 
extent  self-financing;  the  importer's  receipts  often  antedate 
the  cost  of  redeeming  the  bills  of  exchange.  Nor  need  this 
service  to  the  importer  necessarily  imply  a  corresponding  bur- 
den upon  the  exporter,  provided  the  bills  of  exchange  which 
he  draws  can  be  sold  to  the  bankers  as  soon  as  the  shipment  is 
made.  When  this  is  the  case,  the  bill  of  exchange  will  remain 
in  the  hands  of  some  banker  or  money-lender  during  the  inter- 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       291 

val  which  separates  the  exporter's  receipts  and  the  importer's 
payment,  and  will  provide  a  remuneration  for  the  financing 
service  through  its  growth  in  value  as  it  approaches  maturity. 
The  commercial  long  bill,  if  bought  by  the  exporter's  banker, 
plays  a  double  role  in  international  commerce;  it  not  only 
effects  the  collection  of  the  debt  owed  by  importer  to  exporter, 
but,  also,  increases  the  financial  resources  of  the  two  mer- 
chants by  providing  access  to  the  supply  of  loan  funds  in  the 
money  market.  It  must  be  noted,  however,  that  this  double 
service  is  possible  only  when  the  nature  of  the  bill  is  such  as 
to  induce  a  banker  to  buy  it  outright  at  the  time  it  is  drawn. 
The  financing  function  of  bills  of  exchange  is  conditioned  upon 
their  marketability. 

At  this  point  we  may  again  call  attention  to  the  superiorities 
of  the  commercial  letter  of  credit  as  a  financing  agency  in 
international  commerce.  All  drafts  drawn  under  the  au- 
thority of  a  letter  of  credit  are  marketable,  while  most  trade 
bills  are  not;  hence  the  letter  of  credit  places  in  the  exporter's 
hands  an  instrument  capable  of  performing  a  double  economic 
service.  This  results  from  the  fact  that  the  credit  of  a  bank 
has  been  substituted  for  that  of  a  merchant  in  the  capacity  of 
acceptor  of  the  bill,  and,  consequently,  the  buyer  of  the  bill 
bears  a  diminished  risk  of  loss.  An  elaborate  system  of  guar- 
antees, devised  to  safeguard  the  interest  of  the  banks,  makes 
this  substitution  possible.  The  accepting  banker  is  protected 
under  the  terms  of  the  acceptance  account  by  the  uncondi- 
tional liability  of  the  bank  which  issues  the  letter  to  provide 
funds  for  the  redemption  of  all  acceptances;  the  issuing  banker 
is,  in  turn,  protected  by  his  contract  with  the  importer  whose 
terms  hypothecate  the  goods  as  collateral  security,  and,  in 
addition,  gives  the  banker  recourse  to  the  importer's  general 
assets  in  case  of  default.  Substituting  a  banker's  credit  for  a 
merchant's  enables  the  traders  to  appropriate  from  tiie  dis- 
count market  the  funds  needed  to  consummate  the  transac- 
tion. From  the  point  of  view  of  the  importer,  the  goods  are 
bought  on  credit;  they  arrive  in  his  market  in  advance  of  the 
maturity  of  the  drafts  drawn  by  the  exporter,  and  the  im- 
porter gains  possession  of  them  through  the  means  of  a  trust 


29^  FOREIGN  EXCHANGE 

receipt,  or  otherwise,  before  he  is  required  to  pay  their  cost. 
But  the  exporter  sells  them  for  cash —  cash  advanced  by  an 
iniknown  money-lender  of  the  discount  market  whose  aid  is 
tendered  upon  the  strength  of  the  credit  of  the  accepting  bank 
acting  in  behalf  of  the  importer. 

The  ultimate  effect  of  the  financing  service  of  bills  of  ex- 
change is  expanded  trade  between  nations  and  a  more  plenti- 
ful and  a  cheaper  supply  of  goods  in  the  markets  of  the  world. 
Trade  expansion  would  be  confined  within  very  narrow  limits 
if  the  buyer  in  each  instance  were  compelled  to  finance  the 
transaction  out  of  the  liquid  resources  of  his  business,  just  as, 
within  the  domestic  market,  the  gigantic  undertakings  of 
modern  industry  would  be  impossible  if  each  enterpriser  were 
restricted  to  the  use  of  his  own  purchasing  power.  During  the 
year  1920,  goods  of  all  kinds  to  the  enormous  value  of  eight 
billion  dollars  were  sold  by  American  business  men  to  cus- 
tomers of  every  nationality ;  no  such  trade  could  have  taken 
place  upon  terms  of  cash  payment;  its  very  magnitude  is  evi- 
dence of  the  development  of  credit  relations  in  international 
commerce.  But  the  sale  of  goods  on  credit  in  distant  mar- 
kets would  be  hampered  by  almost  insuperable  risks  to  the 
seller  if  his  interests  were  protected  by  no  greater  security 
than  the  good  faith  or  the  solvency  of  an  unknown  customer, 
as  would  be  the  case  w^ere  the  exporter  to  part  with  his  goods 
in  exchange  for  a  promise  to  pay  or  upon  the  basis  of  an 
open  account.  The  private  credit  of  a  merchant  does  not 
extend  far  beyond  the  frontiers  of  his  own  country;  it  does 
not  suffice  to  command  the  goods  of  manufacturers  and  mer- 
chants in  distant  markets.  But  this  private  credit  is  fre- 
quently great  enough  to  procure  from  a  local  banker  a  letter 
of  credit,  which,  placed  in  the  hands  of  a  foreign  seller,  is  ef- 
fective in  extending  the  importer's  purchasing  power  to  the 
products  of  foreign  lands,  thus  increasing  the  supply  of  wares 
in  his  own  market. 

Any  commercial  long  bill,  provided  it  can  be  sold  by  the 
drawer,  has  the  effect  of  bestowing  an  international  credit 
upon  the  importer.  But  the  drawer  of  a  trade  bill  must  carry 
a  risk  of  the  failure  of  his  foreign  customer,  even  after  he  has 


BILLS  OF  EXCHANGE  IN  FOREIGN  TRADE       293 

sold  the  bill  for  cash  to  his  own  banker.  Since  the  legal  right 
of  recourse  to  him  as  drawer  can  be  exercised  by  the  buying 
banker  if  the  importer  refuses,  or  is  unable,  either  to  accept  or 
to  redeem  the  draft,  his  profit  is  subjected  to  the  trade  hazards 
of  the  importer's  business.  On  the  other  hand,  when  em- 
powered to  draw  under  the  authority  of  a  letter  of  credit,  the 
exporter  can  part  with  his  goods  without  concern  as  to  the 
credit  of  his  customer,  since  it  is  only  a  default  by  the  accept- 
ing bank  which  makes  operative  against  him  the  right  of  re- 
course. As  a  financing  agent,  the  commercial  long  bill,  and 
especially  the  long  bill  drawn  against  a  banker,  reduces  the 
credit  risks  in  foreign  commerce,  multiplies  the  exchanges 
which  take  place  between  national  markets,  and,  conse- 
quently, increases  the  quantity  and  reduces  the  price  of  com- 
modities in  the  world's  trading  centers. 

This  beneficial  result  of  the  financing  function  of  bills  of 
exchange  may  be  established  by  a  different  method  of  ap- 
proach. It  is  an  axiom  of  economics  that  goods  in  all  markets 
must  in  the  long  run  command  prices  high  enough  to  cover 
their  costs  of  production.  Among  these  costs  is  one  to  which 
the  name  "financing  cost "  may  properly  be  given,  represented 
by  the  interest  payments  required  to  induce  lenders  of  money 
and  credit  to  advance  the  funds  needed  to  carry  the  operation 
through  its  many  phases.  To  protect  his  profit,  an  exporter 
who  sells  goods  on  credit  must  add  his  loss  of  interest  to  the 
sale  price.  If  the  long  bill  which  he  draws  is  taken  by  the 
bankers  for  collection  (that  is,  if  it  does  not  function  as  a 
financing  agency),  the  exporter  loses  interest  during  the  life  of 
the  bill  at  a  rate  equal  to  that  charged  for  a  loan  by  his  banker 
of  a  similar  amount.  If  the  bill  is  sold,  the  exporter  still  loses 
interest  during  its  life,  but  at  the  rate  used  in  discounting  its 
face  in  order  to  determine  its  present  value;  this  rate  is  estab- 
lished in  the  discount  market  in  which  the  acceptance  is  sold. 
In  either  case,  the  goods  must  be  priced  sufficiently  high  to 
return  this  loss  of  interest  to  the  exporter;  otherwise  we  should 
be  forced  to  the  violent  assumption  that  business  men  choose 
to  forego  a  part  of  their  profit  when  engaging  in  foreign  trade. 

Now,  the  rate  of  discount  applied  to  a  marketable  trade 


204  FOREIGN  EXCHANGE 

bill  is  ordinarily  lower  than  the  rate  demanded  of  a  merchant 
when  contracting  a  loan  at  his  bank,  for  the  reason,  already 
mentioned,  that  a  bill  of  exchange  enjoys  a  higher  standing  as 
a  credit  instrument  than  a  promissory  note;  hence,  when  the 
financing  function  is  discharged  by  a  bill  of  exchange,  the 
interest  cost  of  the  transaction  is  lower  than  when  the  bill 
serves  only  as  an  agency  of  collection,  and  the  sale  price  of 
the  goods  will,  under  competition,  be  correspondingly  lower. 
Similarly,  the  rate  of  discount  applied  to  a  banker's  accept- 
ance is  lower  than  that  commanded  by  the  commercial  trade 
bill,  because  of  the  superior  credit  rating  of  the  acceptor;  and, 
again,  the  necessary  consequence  under  competition  must  be  a 
correspondingly  lower  sale  price  for  the  goods.  In  brief,  when 
a  bill  of  exchange  is  the  financing  agency,  the  cost  of  placing 
the  goods  on  sale  in  the  foreign  market  is  smaller  than  when 
other  means  of  financing  the  transaction  are  employed,  and 
smallest  when  the  bill  used  is  a  banker's  acceptance.  Under- 
lying this  statement  is  the  fact  that  commercial  bills  of  ex- 
change, and  especially  bankers'  acceptances,  throw  open  for 
the  use  of  business  men  engaged  in  foreign  trade  the  resources 
of  the  world's  greatest  banking  centers,  where  funds  can  be  bor- 
rowed for  short  terms  at  the  lowest  possible  rates  of  interest. 


CHAPTER  XI 

FOREIGN  INVESTMENTS  AND  THE  EXCHANGE  MARKET 

67.  Investments  in  long  bills  of  exchange.  The  lending  of 
capital  by  individuals  in  one  country  to  those  in  another,  the 
payment  of  interest  upon  past  loans,  and  the  redemption  of 
maturing  obligations  comprise  a  group  of  forces  of  growing 
magnitude  in  the  exchange  markets  of  the  world.  No  credit 
transaction  involving  individuals  or  governments  of  different 
nations  can  be  carried  through  without  affecting  the  demand 
for,  or  the  supply  of,  foreign  bills  of  exchange  in  the  markets 
concerned,  influencing  the  rates  of  exchange,  and  reacting 
upon  the  currents  of  international  commerce.  Reference  has 
been  made  to  these  forces  at  various  points  in  the  preceding 
chapters;  for  the  purpose  of  studying  them  in  greater  detail, 
we  shall  now  divide  them  into  two  major  groups:  (a)  invest- 
ments of  funds  in  foreign  long  bills  of  exchange;  (b)  invest- 
ments in  foreign  stocks,  bonds,  and  other  securities.  The  first 
of  these  groups  is  the  subject  of  the  present  section. 

Exchange  bankers,  by  virtue  of  their  position  as  middle- 
men handling  a  vast  assortment  of  long  bills,  have  abundant 
opportunity  to  select  for  their  own  uses  those  instruments 
which  possess  the  highest  investment  standing;^  and  it  has 
long  been  their  practice  to  invest  current  funds  in  foreign  long 
bills  whenever  market  conditions  were  favorable.  In  the 
great  majority  of  transactions,  however,  the  purchase  of  a 
long  bill  by  an  exchange  banker  does  not  represent  an  invest- 
ment, or  advance,  of  his  own  funds;  it  is  the  general  rule  of 

^  A  foreign  long  bill,  to  be  considered  an  attractive  investment  by  a  banker, 
must  have  the  following  attributes:  (a)  it  must  be  drawn  upon  a  banker; 
(i)  the  open  market  in  the  drawee's  city  must  be  broad  enough  to  assure  the 
buying  banker  a  ready  sale  of  the  bill  in  case  he  wishes  to  close  out  the  invest- 
ment; (c)  the  bill  must  be  payable  in  gold.  These  attributes  in  the  past  have 
been  possessed,  in  a  preeminent  degree,  by  the  sterling  long  bill  drawn  on  a 
London  banker.  Such  a  bill  has  security,  liquidity,  aud  convertibility  into 
gold  —  all  of  which  are  essential  to  good  bank  assets. 


296  FOREIGN  EXCHANGE 

the  banker's  business  to  offset  purchases  of  long  bills  by  sales 
of  siglil  drafts  at  the  same  time  and  to  substantially  the  same 
amounts.  The  long  bill  is  forwarded  to  the  foreign  corres- 
pondent \\'ith  instructions  to  discount  immediately  afler 
acceptance  has  been  secured,  and  the  sight  drafts,  which  go 
forward  by  the  same  steamer,  exhaust  the  proceeds  of  the 
discount  as  rapidly  as  they  accrue.  By  this  process  of  equal 
purchase  and  sale,  the  banker  is  able  to  conduct  a  large  vol- 
ume of  dealings  in  foreign  bills  without  investing  any  con- 
siderable amount  of  money  on  his  o\\ti  account  in  the  instru- 
ments in  which  he  deals.  His  profit  is  dra\NTi  from  the  slight 
difference  in  his  favor  between  the  rates  at  which  he  buys  and 
sells,  and  does  not  contain  any  element  of  interest  earned  upon 
capital  advanced  by  him,  except  when  he  offsets  his  purchases 
by  sales  of  cables. 

This  standard  transaction  of  the  exchange  banker  has  been 
explained  before,  but  in  order  to  contrast  it  with  the  banker's 
investment  in  a  foreign  bill,  it  may  be  well  to  give  it  emphasis 
by  another  illustration.  Let  us  assume,  then,  that  a  New 
York  banker  is  asked  to  negotiate  a  sterling  long  bill  for  ten 
thousand  pounds,  drawn  on  a  banker  in  London.  In  order 
to  negotiate  this  bill  without  investing  in  it,  the  banker  must 
recover  the  money  he  spends,  immediately.  He  first  calcu- 
lates the  amount  of  sterling  credit  the  bill  will  create  when 
discounted  immediately  after  acceptance  in  London.  Utiliz- 
ing the  appropriate  discount  rate  of  the  London  market  —  let 
us  assume  it  to  be  5  per  cent  —  and  the  bill's  length  of  life 
(sixty  days)  he  finds  the  acceptance  will  sell  for  £9948  4s.  and 
M.  (10,000  X  3/100  H-  63/365).  A  stamp  charge  of  1/20  per 
cent  will  be  levied  in  London;  this  will  reduce  the  amount  by 
£5,  leaving  a  net  sterhng  credit  of  £9943  4s.  and  4;d.  If  the 
sight  rate  for  sterling  on  this  day  is  4.85,  the  banker  can  sell 
this  London  credit  for  $48,224.61  (9943.21  X  4.85),  By  pay- 
ing somewhat  less  than  this  amount  for  the  sterling  long  bill^ 
^  It  is  not  to  be  understood  that  bankers  carry  out  this  calculation  on  the 
occasion  of  each  transaction;  the  sterling  long  rate  is  computed  from  the 
sterling  sight  rate  with  the  intention  of  accomplishing  this  result  of  obviating 
an  advance  of  funds  by  the  buying  banker,  and  this  rate  is  used  for  all  transac- 
tions of  like  character.    See  page  80. 


FOREIGN  INVESTMENTS  297 

and  immediately  proceeding  to  sell  sterling  sight  drafts  which 
will  exhaust  his  London  credit,  the  banker  will  avoid  making 
an  advance  of  fmids  and  yet  draw  a  profit  from  the  transac- 
tion. 

To  tm*n  the  above  transaction  into  an  investment  in  foreign 
exchange,  the  banker  need  only  omit  discounting  the  long  bill 
after  its  acceptance  in  London;^  this  will  prevent  him  from 
selling  the  sterling  sight  draft  and  so  will  result  in  his  making 
an  advance  of  the  funds  expended  when  the  long  bill  is  bought. 
His  decision  to  make  this  investment  will  turn  upon  two 
points  (we  are  assuming  that  the  bill,  itself,  is  an  attractive 
investment  instrument) :  (a)  the  position  of  the  discount  rate 
in  New  York  as  compared  with  the  discount  rate  in  London; 
(6)  the  banker's  forecast  as  to  the  future  trend  of  the  sterling 
sight  rate  in  his  market.  The  influence  of  the  two  discount 
rates  on  the  banker's  decsion  will  become  clear  when  we 
realize  that  the  banker  will  have  an  alternative  use  for  the 
funds  which  he  advances  when  buying  the  long  bill,  and  that 
he  will  choose  the  more  profitable  of  these  alternatives.  By 
keeping  his  money  in  hand,  he  can  make  it  earn  interest  at  the 
rate  prevailing  in  New  York;  by  buying  the  long  bill,  he  will 
gain  the  difference  between  the  price  he  pays  for  it  and  its 
worth  at  maturity,  and  this  difference  will  be  determined  by 
the  interest  rate  of  the  London  market.  In  other  words,  by 
investing  in  this  bill,  the  banker  will  sacrifice  interest  at  the 
New  York  rate  and  gain  interest  at  the  London  rate;  hence, 
the  first  condition  precedent  to  his  decision  to  invest  is  that 
the  London  rate  of  interest  be  higher  than  the  New  York  rate. 

^  It  is  the  act  of  discounting  after  acceptance,  or  refraining  therefrom, 
which  determines  whether  the  burden  of  waiting  for  a  deferred  return  will  be 
thrown  upon  the  money-lenders  of  the  drawee's  or  the  drawer's  market. 
Some  one  must  make  this  advance  of  funds  when  a  long  bill  is  employed  by 
exporter  and  importer.  If  the  exporter  sells  his  bill  outright  to  the  banker 
(and  this  is  the  only  case  we  are  considering),  his  sale  is  resolved  into  an  ex- 
change of  goods  for  cash;  ))ut  the  importer  will  make  no  payment  until  many 
days  later.  When  the  bill  is  sold  in  the  discount  market  after  acceptance,  it 
is  a  money-lender  of  the  drawee's  market  who  bears  the  burden  of  the  ad- 
vance; when  the  discount  does  not  occur,  this  burden  is  borne  by  some  one  in 
the  exporter's  market. 


298  FOREIGN  EXCHANGE 

The  second  condition  has  to  do  with  the  probable  behavior 
of  the  steding  sight  rate  in  the  banker's  market.  The  banker, 
if  he  invests  in  the  sterhng  long  bill,  cannot  wind  up  the  trans- 
action, nor  can  he  ascertain  his  profit,  until  he  has  transferred 
the  proceeds  of  his  investment,  accruing  in  London,  to  his  own 
cash  drawer  in  New  York.  This  he  must  do,  sooner  or  later, 
by  selling  a  sterling  draft  on  the  New  York  market;  and,  since 
all  sterling  rates  are  controlled  by  the  sight  rate,  the  number 
of  dollars  realized  by  the  banker  —  whether  the  draft  he  sells 
is  a  sight  or  a  time  draft  —  will  depend  on  the  position  of  the 
sterling  sight  rate  at  the  time  he  withdraws  his  funds  from  Lon- 
don. Obviously,  if  the  sterling  sight  rate  falls  after  he  makes 
his  investment,  a  part  of  his  gains  will  disappear  in  the  process 
of  transferring  his  funds  from  London  to  New  York.  On  the 
other  hand,  if  the  sight  rate  advances,  his  gain  will  be  in- 
creased when  the  transfer  takes  place.  The  banker  may 
guard  against  the  speculative  element  in  this  transaction  by 
selling  sight  exchange  for  future  delivery;  but  the  rate  of  ex- 
change fixed  in  this  future  contract  will  be  remunerative  to 
the  banker  only  if  it  is  the  feeling  of  the  New  York  market 
that  the  sterling  sight  rate  will  advance,  or,  at  least,  will  not 
fall,  in  the  meantime.  Hence,  it  may  be  said  that,  when  New 
York  bankers  buy  sterling  long  bills  for  investment,  they  give 
evidence  of  their  prediction,  or  the  prediction  of  their  market, 
that  the  trend  of  the  sterling  sight  rate  is  upward. 

It  must  not  be  inferred  from  the  statements  just  made  that 
the  investor  in  a  foreign  long  bill  is  compelled  to  retain  his 
investment  until  the  bill  matures.  Though  he  refrains  from 
discounting  the  bill  immediately  after  acceptance,  the  banker 
does  not  lose  the  power  to  discount  at  any  time  prior  to  ma- 
turity if  conditions  change  so  that  it  becomes  desirable  for 
him  to  release  his  investment.  When  negotiating  a  foreign 
long  bill,  the  banker  sends  the  bill  forward  for  acceptance  in 
the  shortest  space  of  time  irrespective  of  his  decision  regarding 
investment  in  it.  The  securing  of  acceptances  is  equally  im- 
portant whether  the  banker  invests  or  discounts  the  bill. 
The  contingent  liability  of  the  drawer  does  not  become  bind- 
ing unless  an  effort  is  made  to  secure  acceptance  within  a 


FOREIGN  INVESTMENTS  299 

reasonable  space  of  time  after  drawing.  Moreover,  in  the 
case  of  all  bills  payable  after  sight,  the  term  of  life  is  calculated 
from  the  date  of  the  acceptance,  and  the  banker  by  delaying 
presentment  will,  therefore,  receive  no  interest  during  the 
time  lost  in  securing  acceptance.  These  considerations  in- 
duce the  bankers  to  forward  bills  bought  for  investment  as 
quickly  as  they  do  those  which  they  discount.  But  the  pro- 
cedure of  forwarding  varies  slightly  in  the  two  cases.  The 
practice  of  the  market,  when  it  is  the  banker's  intention  to 
discount,  is  to  endorse  and  forward  by  separate  mails  both 
the  first  and  second  of  exchange,  either  of  which  may  be  pre- 
sented for  acceptance,  thus  voiding  the  other.  However, 
when  the  banker  decides  to  invest  in  the  bill,  the  first  of  ex- 
change is  sent  forward  for  acceptance  vnthout  endorsement, 
while  the  second  is  retained  by  the  banker.  The  accepted 
bill  cannot  be  discounted,  since  it  lacks  the  banker's  endorse- 
ment, but  the  second  may  be  endorsed  and  sent  forward  when- 
ever it  is  desired  to  terminate  the  investment;  the  two  copies, 
one  bearing  the  drawee's  acceptance  and  the  other  the  payee's 
endorsement,  make  a  discountable  instrument.  The  foreign 
bill  of  exchange,  if  drawn  on  a  city  in  which  exists  a  ready 
discount  market,  is,  therefore,  a  highly  convertible  instru- 
ment. 

Under  normal  conditions,  it  is  not  often  that  money-lenders 
other  than  bankers  invest  in  bills  of  exchange  drawn  upon, 
and  payable  in,  foreign  markets.  But  one  result  of  tlie  ab- 
normal exchange  conditions  which  have  followed  the  close  of 
the  Great  War,  has  been  the  attraction  into  the  market  of 
investors  and  speculators  from  the  outside,  persons  with 
money  to  lend,  who  have  responded  to  the  lure  of  the  ex- 
tremely low  sight  rates  and  bought  foreign  bills  in  the  hope  of 
a  rising  market.  The  bankers  have  encouraged  and  facili- 
tated this  contribution  to  the  investment  funds  of  the  market 
by  advancing  a  part,  sometimes  one  half,  of  the  purchasing 
price,  using  the  endorsed  copy  of  the  bill  as  security  in  the 
transaction  —  a  process  similar  to  margin  speculation  on  the 
stock  exchange.  Another  method  of  facilitating  these  invest- 
ments used  by  the  bankers  is  the  drawing  of  long  "date"  bills 


800  FOREIGN  EXCHANGE 

as  substitutes  for  long  acooi)tance  bills;  the  banker  takes  the 
long  acceptance  bill  and  covers  it  by  selling  his  own  long  date 
bill  for  a  similar  amount  to  another  investor.  The  date  bills 
are  convenient  instruments  for  those  who  have  no  corres- 
pondents in  the  foreign  market  through  whom  to  obtain  ac- 
ceptance. They  are  drawn  for  periods  which  are  usually  ten 
days  longer  than  those  customary  in  long  sight  exchange;  that 
is,  a  date  bill  of  seventy  days  will  correspond  to  a  sight  bill 
of  sixty,  and  a  date  bill  of  one  hundred  days  to  a  sight  bill  of 
ninety.  The  investor  can  hold  such  a  bill  until  it  is  within 
ten  days  of  maturity  and  then  sell  it  as  sight  exchange,  since 
it  will  then  be  payable  on  arrival  in  the  foreign  market  (allow- 
ing ten  days  for  the  passage  through  the  mails).  This  makes 
it  possible  for  the  investor  to  withdraw  his  funds  within  the 
sixty  and  ninety  day  periods  customary  in  dealing  in  long 
sight  bills.  Bankers  who  issue  these  date  bills  usually  allow 
the  investor  the  option  of  returning  them  ten  days  before  ma- 
turity to  be  swapped  for  sight  exchange  on  the  same  market. 
At  one  time  during  the  recent  unsettlement  of  the  exchange 
market  there  was  considerable  speculation  in  bankers'  sight 
exchange,  which  partook  of  the  nature  of  investment  for  short 
periods.  The  speculator  bought  bankers'  checks  payable  in  a 
given  foreign  city,  not  with  the  intention  of  forwarding  them 
for  payment,  but  with  a  view  toward  holding  them  for  a  rise 
in  the  exchange  rates  and  of  selling  them  in  the  New  York 
market  at  a  later  date.  During  the  period  when  these  sight 
drafts  were  held  oflf  the  market,  the  transaction  had  the  same 
effect  as  any  investment  in  foreign  bills.  Many  of  the  bank- 
ers, objecting  to  this  practice  because  the  delay  in  forwarding 
the  drafts  increased  the  risk  of  failure  by  the  foreign  corres- 
pondent and  of  recourse  to  themselves,  have  put  a  stop  to  the 
practice  by  stamping  upon  their  demand  drafts  a  clause  re- 
quiring that  they  be  presented  within  a  certain  space  of  time 
at  the  office  of  the  foreign  correspondent.  This  type  of  in- 
vestment is,  therefore,  not  so  frequent  as  it  once  was;  specu- 
lators have  turned  to  the  purchase  of  the  paper  moneys  of 
the  countries  in  whose  exchange  they  wish  to  speculate  as  a 
transaction  very  similar  to  that  of  buying  bankers'  sight  upon 


FOREIGN  INVESTMENTS  301 

these  countries.  Short  term  investment  in  bankers'  sight 
drafts  is  still  carried  on,  however,  to  a  certain  extent. 

One  other  form  of  investment  in  foreign  bills  has  arisen  in 
recent  years  as  the  result  of  the  credit  strain  following  the 
Great  War.  The  prostration  of  Europe,  and  the  inability  of 
importers  of  even  the  highest  credit  rating  to  make  current 
payments  for  goods  bought  in  the  United  States  without  great 
losses  in  exchange  charges,  have  induced  many  American 
sellers  to  cooperate  with  their  foreign  customers  to  ease  the 
situation.  Liberal  credit  terms  are  extended  —  terms  of 
nine  months  or  a  year  —  and  bills  of  exchange  bearing  the 
return  draft  requirement  are  drawn  for  these  periods,  ac- 
cepted by  the  foreign  importers,  or  their  agents  in  this  coun- 
try, and  held  by  the  exporters  until  maturity.  This  arrange- 
ment has  the  purpose  of  giving  the  importer  time  to  complete 
the  transaction  for  which  the  goods  were  bought  before  mak- 
ing payment,  and,  at  the  same  time,  of  relieving  the  exporter 
from  the  necessity  of  selling  his  bill  in  a  low  market.  The 
return  draft  requirement,  it  may  be  well  to  state,  obligates 
the  acceptor  to  redeem  his  bill  at  maturity  in  dollar  sight 
drafts;  thus  the  drawer  is  not  required  to  negotiate  the  bill  at 
any  time.  Obviously,  such  transactions  as  these  merely 
represent  a  different  method  of  selling  goods  on  open  account; 
the  investment  made  by  the  exporter  is  equal  to  the  value  of 
the  goods  he  agrees  to  ship  now  in  consideration  of  a  deferred 
return,  and  his  interest  charge  is  added  to  the  sale  price  of 
the  goods.  In  reality,  a  large  part  of  the  capital  of  exporters 
locked  up  in  investments  of  this  kind  has  been  advanced  by 
the  banks  through  an  indirect  process.  With  their  working 
capital  absorbed  in  these  long-term  foreign  credits,  exporters 
have  been  compelled  to  resort  to  the  banks  for  loans  with 
which  to  carry  on  their  domestic  transactions,  availing  them- 
selves of  the  customary  "line  of  credit"  established  by  bank- 
ers in  favor  of  their  clients.  Though  borrowing  ostensibly 
for  a  different  purpose,  the  exporters'  demand  for  bank  credit 
has  been  increased  by  the  inability  of  the  exchange  market  to 
liquidate  foreign  transactions. 

Investment  in  foreign  long  bills  in  any  of  these  forms  exerts 


S02  FOREIGN  EXCHANGE 

its  effect  upon  the  exchange  market  by  temporarily  reducing 
the  amount  of  sight  dral'ls  oUcrcd  for  sale.  The  obvious 
result  of  this  is  to  raise  the  sight  rate  (and,  consequently,  the 
rates  for  long  bills),  or,  at  least,  to  prevent  the  rates  from  fall- 
ing as  far  as  they  might  otherwise  do.  To  establish  the  truth 
of  this  statement,  it  need  only  be  recalled  that  the  essence  of 
an  investment  in  foreign  bills,  from  the  standpoint  of  the 
banker,  is  the  decision  to  postpone  the  use  of  these  bills  as 
cover  for  sight  drafts  until  a  later  date.  A  substantial  vol- 
ume of  such  investments  will  lend  support  to  the  exchange 
market  at  a  time  when  the  rates  are  falling  under  the  pressure 
of  a  large  volume  of  bankers'  sight  drafts,  as,  for  example, 
during  the  years  immediately  following  the  Great  War,  when 
exports  so  vastly  outweighed  imports  in  the  foreign  trade  of 
the  United  States.  But  unless  the  investments  are  renewed 
at  maturity  by  the  substitution  of  new  long  bills,  their  effect 
upon  the  exchange  market  will  be  brief;  maturing  bills  will  be 
brought  back  to  the  market,  thus  giving  rise  to  the  volume  of 
sight  drafts  which  was  removed  when  the  investment  was 
made.  Moreover,  since  the  long  bills  have  a  higher  value  at 
maturity  than  they  have  when  drawn,  and  create  a  larger 
foreign  credit  when  held  for  investment  on  this  side,  the  in- 
vestment process  will  increase  as  well  as  postpone  the  volume 
of  sight  drafts. 

68.  Foreign  long-term  investments.  The  initial  effect 
upon  the  exchange  market  of  investing  in  foreign  stocks, 
bonds,  and  similar  long-term  securities,  is  not  different  from 
that  of  investments  in  foreign  bills  of  exchange.  The  buyers 
of  foreign  securities  place  their  funds  in  the  hands  of  domestic 
bankers  who  undertake  to  forward  them  to  the  borrowers  in 
the  foreign  countries.  The  forwarding  of  the  funds  may  be 
effected  in  either  of  two  ways.  The  domestic  bankers  may  buy 
drafts  payable  in  the  borrowers'  country  for  remittance  to  the 
borrowers  or  their  bankers;  or,  the  borrowers  may  be  instructed 
to  draw  for  the  amount  in  question  upon  this  market.  Ob- 
viously, both  of  these  methods  of  payment  will  increase  the 
demand  for  foreign  bills  in  the  lending  market.  In  the  first 
case,  this  is  done  directly;  for  the  banker  who  has  received 


FOREIGN  INVESTMENTS  SOS 

the  investor's  money  turns  it  into  drafts  for  remittance  to  the 
sellers  of  the  securities.  In  the  second  case,  the  process  is 
indirect,  but  not  substantially  different  in  its  effects.  The 
bills  drawn  by  the  sellers  of  the  securities  will  be  bought  by 
some  one  in  the  foreign  market  and  forwarded  for  redemption 
by  the  banker  who  has  received  the  investor's  money;  this 
will  leave  the  banker's  market  in  the  debt  of  the  borrowing 
market  and  increase  by  so  much  the  need  of  making  remit- 
tances of  foreign  bills.  Consequently,  the  purchase  of  foreign 
securities  by  American  investors  tends  to  raise  the  sight  rate 
on  foreign  bills  and  the  other  rates  of  exchange  which  depend 
upon  it. 

Again,  the  influence  of  these  long-term  investments  at  the 
time  of  maturity  does  not  differ  from  that  exerted  by  invest- 
ments in  long  bills  of  exchange.  Unless  new  securities  are 
substituted  for  those  which  have  matured,  the  investors  will 
withdraw  their  funds  by  placing  their  securities  in  the  hands 
of  some  domestic  banker  to  be  redeemed  and  cancelled.  The 
redemption  of  these  securities  will  give  the  bankers  foreign 
credits  against  which  to  draw  sight  drafts,  thus  adding  so 
much  to  the  supply  of  these  drafts  on  the  market  and  tending 
to  depress  the  rate  of  exchange.  Between  these  two  points  in 
their  history  —  their  purchase  by  American  investors  and 
their  redemption  by  the  foreign  borrowers  —  foreign  securi- 
ties give  their  owners  the  right  to  receive  periodic  payments 
of  interest.  These  payments  increase  the  supply  of  exchange 
drawn  on  the  borrowing  market.  The  investors  clip  their 
coupons,  and  pass  them  to  the  bankers  for  negotiation;  the 
coupons  constitute  just  so  much  sight  exchange  payable  in 
the  debtors'  market. 

As  the  amount  of  foreign  securities  held  by  investors  within 
the  country  increases  from  year  to  year,  and  the  size  of  the 
annual  interest  payments  mounts,  two  counteracting  forces 
are  brought  to  bear  upon  the  exchange  market.  The  new 
investments  create  a  demand  for  foreign  bills;  the  interest 
payments,  a  supply  of  these  bills.  Usually,  during  the  early 
years  of  its  experience  as  a  lending  nation,  the  annual  addi- 
tions to  the  foreign  securities  held  by  a  country's  citizens 


304  FOREIGN  EXCHANGE 

outweighs  the  sums  owing  on  account  of  interest  payments 
and  maturing  investments,  with  the  result  that  these  inter- 
national loans  create  a  net  annual  addition  to  the  demand  for 
foreign  bills  in  the  nation's  market.  This  period,  however, 
can  scarcely  continue  indefinitely;  for  the  increasing  interest 
payments  plus  maturities  will,  in  time,  overbalance  new  in- 
vestments and  reverse  the  effect  upon  the  exchange  market, 
by  creating  a  net  addition  to  the  supply  of  foreign  bills, 

69.  The  effect  of  investments  on  international  commerce. 
The  chief  significance  of  the  forces  we  have  been  considering 
lies  beyond  their  effect  upon  the  exchange  market  and  inheres 
in  the  influence  which  they  exert  through  the  medium  of  that 
market  upon  the  currents  of  international  commerce;  to  these 
ulterior  effects  we  now  turn.  Between  individuals,  the  cred- 
itor-debtor relationship  is  usually  created  by  some  such  proc- 
ess as  the  following:  A  surrenders  something  of  value  to  B, 
receiving  no  immediate  payment  except  in  the  form  of  B*s 
promise  to  make  payment  some  time  in  the  future;  A  is  then 
B's  creditor  until  the  deferred  payment  takes  place.  When 
we  view  the  different  nations  as  trading  units  whose  relations 
with  each  other  are  analogous  to  those  of  individuals,  it  is 
apparent  that  one  nation  can  become  the  creditor  of  another 
only  through  a  substantially  similar  process.  Nation  A  de- 
livers valuable  goods  or  services  to  nation  B,  receiving  no 
current  payment  other  than  some  evidence  of  indebtedness; 
henceforth,  nation  A  is  the  creditor  of  nation  B  until  the  de- 
ferred payment  takes  place.  When  paying  interest  or  redeem- 
ing maturing  obligations,  nation  B  must  reverse  this  process 
and  surrender  valuable  goods  or  services  without  receiving 
payment  other  than  a  release  from  debt.  To  state  the  matter 
in  other  words,  the  lending  nation  attains  its  creditor  position 
by  reason  of  a  favorable  balance  of  trade  —  that  is,  an  excess 
of  goods  and  services  exported  over  goods  and  services  im- 
ported; w^hen  the  point  is  reached  at  which  annual  interest 
receipts  plus  maturing  obligations  exceed  the  aggregate  of 
annual  new  investments,  the  balance  of  trade  becomes  "un- 
favorable." Obviously,  no  nation  can  lend  its  lands,  mines, 
or  other  immovable  wealth;  it  can  surrender  to  foreign  people 


FOREIGN  INVESTMENTS  805 

only  those  things  which  enter  into  international  commerce  — 
that  is,  the  products  of  its  capital  and  labor.  Equally  obvious 
is  it  that,  if  the  nation  is  to  lend  these  things  and  not  merely  to 
sell  them,  she  must  fail  to  receive  payment  in  the  form  of  other 
products  exchanged  for  them.  Likewise,  the  creditor  nation 
must  accept  from  the  debtor,  in  payment  of  interest  and 
maturing  obligations,  the  valuable  products  of  the  debtor 
nation's  capital  and  labor,  since  the  payment  can  take  no 
other  form. 

When  thus  simplijBed  by  disregarding  the  multitudinous 
transactions  of  individuals  and  viewing  only  the  relationships 
of  the  nations  as  a  whole,  the  effect  of  foreign  investments 
upon  international  commerce  becomes  quite  clear:  the  pur- 
chase of  foreign  securities,  or  of  foreign  bills  of  exchange,  by 
individuals  within  the  country  enables  a  nation  to  export 
more  than  she  imports.  But  the  actual  process  of  the  ex- 
change market,  by  means  of  which  myriads  of  unrelated 
transactions  work  out  this  national  result,  remains  to  be  ex- 
plained. Let  us  consider  first  the  investment  in  a  foreign  bill 
of  exchange.  We  have  seen  that,  in  order  to  buy  a  commer- 
cial long  bill  without  making  an  advance  of  funds,  the  banker 
must  recover  his  money  immediately  by  selling  a  demand 
draft  of  equal  value.  The  fact  that  he  is  able  to  sell  this  de- 
mand draft  is  proof  that  some  individual  in  his  market  is 
under  obligation  to  make  a  remittance  abroad,  an  obligation 
which  is  the  result  of  the  receipt  from  abroad  of  a  valuable 
consideration  —  either  goods  or  services  imported,  or  a  re- 
lease from  a  previous  debt,  or  a  property  right  in  the  wealth 
of  a  foreign  people,  or  something  else.  The  banker's  purchase 
price  for  the  commercial  long  bill  represents  an  exporter's 
receipt  for  something  of  value  exported;  the  banker's  sale 
price  for  the  demand  draft  represents  an  importer's  payment 
for  something  of  value  imported;  any  discrepancy  between 
these  two  amounts  is  the  banker's  remuneration  for  his  serv- 
ices as  a  middleman.  If  the  two  commercial  transactions  in 
which  the  long  bill  and  the  demand  draft  are  employed 
be  brought  together  in  a  single  account,  it  will  appear 
that  the  nation  has  both  given  up  and  received  things  of 


SOa  FOREIGN  EXCHANGE 

equivalent  value,  although  each  business  man  carries  on  his 
transaction  with  a  view  solely  to  his  own  profit  and  with  no 
thought  as  to  the  effect  upon  the  nation's  trade  as  a  whole. 
This  is  not  to  say  that  the  exports  must  have  gone  to  the  coun- 
try from  which  came  the  imports;  for  we  know  that  sterling 
long  bills  (for  example)  are  used  to  finance  exports  to  other 
countries  than  England,  and  sterling  demand  drafts  to  pay 
for  imports  from  other  countries  than  England. 

Contrast  with  this  result  the  effect  of  the  banker's  invest- 
ment in  the  commercial  long  bill.  His  purchase  price,  as 
before,  makes  payment  to  some  exporter  for  something  of 
value  which  has  left  the  shores  of  the  nation;  but  his  decision 
not  to  use  the  long  bill  as  cover  for  a  demand  draft  prevents 
this  particular  export  item  from  being  offset  imm.ediately 
against  an  import  item.  If  this  type  of  investment  runs  on  for 
a  considerable  period  of  time,  and  if  the  sum  total  of  foreign 
long  bills  held  by  investors  steadily  increases,  the  nation  will 
continue  to  export  goods  without  receiving  payment  for  them. 
For  the  sake  of  emphasis,  we  may  repeat  that  these  exports 
need  not  go  to  the  nation,  or  nations,  in  whose  bills  of  ex- 
change the  investments  are  made;  the  whole  trade  of  the 
nation  must  be  taken  into  account  when  tracing  out  the  ef- 
fects of  these  investments,  but  W'hen  this  view  is  taken,  the 
fact  is  clear  that  foreign  investments  enable  the  nation  to 
finance  an  excess  of  exports.  Except  for  these  investm.ents, 
an  excess  of  exports  would  create  a  supply  of  sight  drafts  so 
large  in  proportion  to  the  demand  for  them,  that  the  exchange 
rates  would  decline  to  the  point  where  exports  were  burdened 
and  imports  stimulated,  thus  tending  to  restore  equilibrium 
in  the  foreign  comm.erce  of  the  nation. 

Although  an  excess  of  exports  can  be  financed  through  the 
purchase  of  foreign  long  bills  for  investment,  this  type  of 
investment  is  so  short-lived  that  it  can  afford  only  temporary 
relief  to  the  exchange  market.  The  typical  commercial 
long  bill  runs  for  ninety  days  from  sight;  when  such  a  bill  is 
bought  for  investment,  the  drawing  of  sight  drafts  against  the 
value  of  the  goods  sold  abroad  will  be  postponed  for  a  short 
time  only;  and  when  the  drawing  occurs,  the  amount  of  sight 


FOREIGN  INVESTMENTS  S07 

drafts  will  have  been  increased  by  the  act  of  investment. 
Unless  the  investment  operation  is  repeated  by  the  substi- 
tution of  new  bills  for  maturing  ones,  and  unless  the  amount 
held  by  investors  constantly  increases,  the  excess  of  exports 
will  soon  make  itself  felt  on  the  exchange  market.  The  sight 
rate  will  fall  under  the  pressure  of  the  drafts  drawn  to  close 
out  the  investments,  and  the  declining  rate  mil  either  cause 
an  inflow  of  gold  which  will  raise  prices  and  diminish  for- 
eign sales;  or,  if  the  inflow  of  gold  is  prevented,  a  burdensome 
exchange  charge  will  develop  which  so  increases  the  foreign 
buyer's  expense  of  making  payment  as  to  diminish  exports. 
Relief  for  the  exchange  market,  when  the  nation  has  a  contin- 
ued excess  of  exports,  must  be  sought  from  foreign  invest- 
ments of  longer  term  than  the  foreign  long  bill  of  exchange. 
Long-term  investments,  once  made,  do  not  soon  return  to 
disturb  the  exchange  market;  years  or  decades  may  elapse 
before  the  funds  are  withdrawn,  and,  during  this  period,  a 
gro'\\ang  volume  of  such  investments  will  lend  support  to  the 
exchange  market  and  permit  a  long-continued  favorable  bal- 
ance of  trade. 

But  the  exporters  of  goods  are  not  often  content  to  dis- 
pose of  their  wares  in  exchange  for  long-term  promises  to  pay. 
Business  men  engaged  in  production  and  merchandising 
must  liquidate  their  sales  within  short  periods  in  order  to  meet 
recurring  costs;  they  could  not  continue  long  in  business  if 
they  were  to  obligate  themselves  to  meet  their  costs  in  cash 
while  conducting  their  sales  on  long  credits.  Hence,  the 
persons  directly  responsible  for  the  excess  of  exports  are  not 
the  ones  who  acquire  the  foreign  securities  against  which  these 
exports  are  offset.  The  exporters  dispose  of  their  bills  of  ex- 
change in  the  usual  ways,  either  selling  them  for  cash  to  the 
bankers  or  depositing  them  for  collection;  in  either  case,  they 
receive  money  payment  for  their  goods,  though  the  nation 
of  which  they  are  a  part  receives  neither  money  nor  anything 
else  more  tangible  than  a  promise  to  pay.  However,  there 
are  other  individuals  within  the  country  who,  with  money  to 
invest,  are  willing  to  buy  foreign  stocks  and  bonds  solely  on 
their  merits  as  investment  instruments.  These  money-lenders 


308  FOREIGN  EXCHANGE 

arc  in  no  wise  concerned  with  the  Scales  problems  of  the  ex- 
porters; yet,  by  transferrinc;  tlieir  funds  to  domestic  bankers 
for  the  purchase  of  foreign  securities,  they  create  a  demand  for 
bills  of  exchange  which  takes  off  the  market  those  drawn  by 
the  exporters  and  thus  permits  the  latter  to  receive  cash  for  the 
goods  they  sell  abroad.  If  no  one  in  the  comitry  were  con- 
tent to  invest  in  foreign  securities,  the  exporters  would  be 
forced  to  rely  for  the  sale  of  their  bills  upon  funds  placed  in  the 
bankers'  hands  by  the  purchasers  of  demand  drafts  —  that  is, 
by  the  importers  —  and  the  problem  of  jBnancing  an  excess  of 
exports  would  soon  grow  acute. 

By  a  similar  process,  the  overturn  of  the  nation's  trade  bal- 
ance, which  occurs  when  interest  receipts  annually  outweigh 
new  loans,  is  financed  through  the  medium  of  the  exchange 
market.  Individual  importers  make  payment  in  the  usual 
ways,  either  by  remitting  demand  drafts  or  redeeming  the 
bills  of  their  foreign  creditors.  But  with  the  supply  of  foreign 
bills  brought  to  the  market  by  investors  to  whom  interest 
payments  are  due  from  abroad  added  to  the  supply  offered 
by  the  exporters,  the  demand  of  importers  will  clear  the  mar- 
ket only  on  condition  that  imports  are  in  excess  of  exports; 
and,  if  the  market  is  not  cleared,  the  rates  of  exchange  will 
fall  to  the  point  where  exports  are  burdened  and  imports 
stimulated.  The  investors  present  their  interest  coupons  to 
the  bankers,  who,  by  negotiating  them,  acquire  the  right  to 
draw  foreign  bills.  The  market  for  these  bankers'  bills  is 
among  the  importers;  if  they  buy  them  all,  in  addition  to 
those  drawn  against  the  bills  of  exporters,  we  have  proof  that 
imports  are  in  excess  of  exports.  The  declining  rate  of  ex- 
change will  produce  this  excess  of  imports  in  case  it  is  not 
present  at  the  outset. 

The  relationship  between  foreign  investments  and  the  cur- 
rents of  international  commerce  may  be  illustrated  from  the 
trade  history  of  the  United  States.  As  a  young  country, 
possessed  of  undeveloped  resources,  the  United  States  was  a 
borrowing  nation,  importing  goods  and  services  in  excess  of 
exports  and  offsetting  the  unfavorable  balance  of  trade  by 
selling  in  foreign  markets  the  stocks  and  bonds  of  her  indus- 


FOREIGN  INVESTMENTS  309 

tries  and  governments.  The  sale  of  these  securities  created 
foreign  credits  in  favor  of  American  banks  against  which  bills 
were  drawn  in  payment  of  the  excess  of  imports.  Succeeding 
this  stage,  and  as  a  consequence  of  it,  the  United  States  was 
placed  in  the  position  of  a  debtor  nation  whose  obligations 
to  make  remittances  of  interest  and  principal  exceeded  her 
annual  borrowings  from  abroad,  leaving  a  net  payment  to  be 
discharged  by  means  of  an  excess  of  exports.  The  American 
bankers  who  made  these  payments  on  behalf  of  the  debtors 
within  the  country  employed  foreign  bills  of  exchange  for 
this  purpose,  thus  affording  an  outlet  for  the  bills  of  exporters. 
These  two  periods  covered  the  history  of  the  United  States 
from  its  origin  as  an  independent  nation  down  to  the  outbreak 
of  the  Great  War. 

The  effect  of  the  war  was  suddenly  to  make  of  the  United 
States  a  lending  nation.  American  securities  owned  abroad 
were  returned  to  this  market  in  large  volume,  thus  reducing 
the  indebtedness  of  our  country  to  foreign  peoples;  and,  at  the 
same  time,  immense  loans  were  made  by  our  Government  to 
foreign  nations.  Both  of  these  currents  of  securities  were  off- 
set against  the  unprecedented  excess  of  merchandise  exports 
which  characterized  the  trade  statement  of  the  United  States 
from  the  outbreak  of  the  war  down  to  the  present  time  (1921). 
The  sale  on  our  market  of  foreign  owned  securities,  and  of  the 
bonds  of  foreign  governments,  combined  to  place  American 
banks  under  obligation  to  make  remittances  abroad,  thus 
creating  a  demand  for  the  foreign  bills  of  the  exporters  who, 
otherwise,  would  have  found  no  purchasers.  At  the  present 
time,  the  United  States  continues  to  have  a  large  favorable 
balance  of  trade;  but  that  the  increase  in  our  foreign  invest- 
ments no  longer  suffices  to  finance  the  excess  of  exports  is 
evidenced  by  the  collapse  of  the  rates  of  exchange  and  the 
difficulty  of  negotiating  foreign  commercial  bills.  Short-term 
investments  in  foreign  long  bills  have  afforded  some  measure 
of  relief  to  the  overburdened  exchange  market.  However, 
unless  there  is  an  increased  and  continued  purchase  by  Amer- 
ican investors  of  foreign  long-term  securities,  the  favorable 
balance  of  trade  must  decline  and  disappear  as  the  handicap 


810  FOREIGN  EXCHANGE 

upon  our  export  trade  imposed  by  the  premium  on  the  dollar 
in  foreign  markets  grows  progressively  heavier.  Eventually, 
in  any  event,  the  growing  interest  payments  due  our  investors 
must  cause  an  overturn  of  the  trade  balance;  additional 
foreign  investments  will  postpone  this  event,  but  not  avert  it 
entirely. 

Certain  aspects  of  the  relationship  of  foreign  investments 
to  international  commerce  require  further  explanation.  The 
position  of  the  United  States  at  the  present  time,  at  the  con- 
clusion of  a  period  of  lending  marked  by  a  continued  excess 
of  exports,  and  upon  the  verge  of  the  succeeding  period  when, 
as  a  creditor  nation,  she  must  receive  large  annual  interest 
payments  in  the  form  of  imports,  has  alarmed  many  people 
who  have  imperfectly  grasped  the  relation  of  the  exchange 
market  to  foreign  commerce.  It  is  feared  that,  since  the  in- 
dustries of  the  country  have  been  adjusted  to  a  large  volume 
of  exports,  the  influx  of  imports  will  unsettle  our  industrial 
structure  and  undermine  the  economic  prosperity  of  the  nation. 
This  fear  is  to  a  large  extent  founded  upon  a  misapprehension  : 
namely,  that  the  imports  sent  to  us  in  payment  of  interest 
must  of  necessity  be  the  products  of  the  countries  which  are 
our  debtors.  It  happens  that  the  securities  we  own  are  those 
of  manufacturing  nations  whose  products  would  enter  into 
competition  with  our  own  and  thus  conflict  with  our  tradi- 
tional protectionist  policy.  But  these  imports  need  not  come 
from  the  nations  which  are  under  obligation  to  pay  us  interest. 
As  explained  above,  our  right  to  receive  interest  payments 
will  create  a  supply  of  exchange  drawn  upon  the  debtor 
countries,  but  this  exchange  may  be  used  to  effect  payment  for 
imports  from  any  quarter  of  the  world,  provided  this  mode  of 
payment  is  acceptable  to  the  exporters.  By  a  triangular 
process,  our  sterling  and  franc  exchange  may  be  transferred 
to  exporters  in  South  America,  the  Far  East,  or  Australasia 
in  payment  for  the  products  of  these  countries,  to  be  used  by 
the  exporters  to  discharge  payments  due  to  France  and  Eng- 
land. The  exchange  market  acts  as  a  clearing  house  for 
foreign  credits  and  debits  arising  from  the  total  commerce  of 
the  nation;  it  is  the  balance  of  commerce  with  the  world  in 


FOREIGN  INVESTMENTS  311 

general  which  is  affected  by  the  forces  we  have  been  explain- 
ing. When,  as  a  result  of  investments,  the  nation  is  empow- 
ered to  receive  a  net  payment  from  abroad,  this  payment  will 
take  the  form  of  an  excess  of  imports  in  her  total  commerce; 
and  attempts  to  prevent  this  result  by  means  of  prohiliitive 
tariffs  or  otherwise,  unless  these  attempts  actually  destroy  the 
right  of  the  creditors  to  receive  their  interest,  must  prove  in- 
effectual. The  pressure  of  foreign  bills  upon  the  exchange 
market  will  bear  down  the  rates  to  the  point  where  im- 
ports become  profitable  despite  a  penalizing  governmental 
policy. 

70.  Investment  trusts.  Realization  of  the  fact  that  Amer- 
ican investment  in  foreign  securities  is  now  essential  to  a  con- 
tinuance of  our  favorable  balance  of  trade  has  stimulated  in- 
terest in  the  agencies  which  undertake  to  create  a  demand  for 
these  securities  among  the  investing  public.  It  does  not  fall 
within  the  compass  of  our  subject  to  describe  these  agencies 
at  length;  one  of  them,  however,  relies  for  the  consummation 
of  its  purpose  upon  direct  intervention  in  the  exchange  mar- 
ket, and  to  this  some  attention  may  profitably  be  given.  This 
is  the  investment  trust,  organized  under  the  Edge  Act.  Its 
function,  expressed  in  summary  form,  embraces  the  following 
operations:  First,  it  takes  over  the  long-term  securities  of 
foreign  borrowers  who  desire  to  establish  a  credit  in  the  United 
States  for  the  purchase  of  American  goods;  against  these  se- 
curities as  collateral,  the  trust  issues  its  own  debentures  to 
American  investors;  finally,  it  uses  the  funds  acquired  in  this 
manner  to  take  up  the  bills  of  exporters  whose  products  the 
foreign  borrowers  wish  to  obtain.  From  the  standpoint  of  the 
nation,  these  processes  achieve  the  same  result  as  does  any  for- 
eign investment:  goods  are  exchanged  for  long-term  promises 
to  pay.  But  the  problem  of  placing  these  long-term  promises 
with  American  investors  is  obviated  by  the  expedient  of 
substituting  for  them  the  bonds  of  an  American  financial 
corporation  whose  credit  obligations  find  a  much  readier 
market  with  the  investing  pul)lic.  The  scheme  is  especially 
devised  to  relieve  the  exchange  market  from  the  pressure  of 
exporters'  bills  at  a  time  when  the  trade  balance  is  favorable. 


312  FOREIGN  EXCILVNGE 

by  calHn£T  forth  the  investment  funds  of  the  money-lenders 
for  the  purchase  of  these  bills  by  a  roundabout  process. 

In  foreign  countries,  financial  institutions  of  this  kind  have 
long  been  in  operation,  and  under  the  banking  laws  of  cer- 
tain states,  similar  institutions  have  been  carrying  on  substan- 
tially similar  operations  in  the  United  States.  An  amendment 
to  the  Federal  Reserve  Law,  passed  in  1916,  empowered  na- 
tional banks  with  a  capital  of  $1,000,000  or  more  to  invest  not 
more  than  ten  per  cent  of  their  capital  and  surplus  in  such  cor- 
porations; the  McClean  Act,  which  became  a  law  in  Septem- 
ber, 1919,  removed  the  limit  set  by  the  prescription  of  a  min- 
imum capital  and  permitted  all  national  banks  to  cooperate  in 
forming  investment  trusts  by  subscribing  not  more  than 
five  per  cent  of  their  capital  and  surplus;  finally,  the  Edge 
Act,  passed  at  the  close  of  1919,  provided  for  federal  incor- 
poration of  investment  trusts,  prescribed  regulations  to  govern 
their  activities,  and  placed  them  under  the  supervision  of  the 
Federal  Reserve  Board.  Financial  institutions  incorporated 
under  federal  law  with  a  minimum  capital  of  $2,000,000  may 
now  accept  long-term  securities  as  collateral  for  their  own 
debentures,  issuing  the  latter  to  an  amount  not  to  exceed  ten 
times  their  capital  and  surplus.  With  the  funds  raised  by  the 
sale  of  their  debentures,  these  corporations  may  buy  exchange 
in  the  open  market,  or  negotiate  the  bills  of  particular  export- 
ers. The  functioning  of  these  institutions  on  a  large  scale 
will  relieve  the  pressure  of  commercial  bills  upon  the  exchange 
market,  and  so  furnish  a  means  of  financing  a  favorable  bal- 
ance of  trade. 


CHAPTER  XII 

THE  EXCHANGE  MARKET  —  LONDON 

The  most  casual  student  of  foreign  exchange  has  frequently 
come  upon  such  statements  as  these:  "London  is  the  center 
of  the  world's  trade";  "the  vast  preponderance  of  interna- 
tional trade  is  financed  with  sterling  bills";  "the  exchange 
business  of  the  world  is  cleared  through  London."  The 
truth  of  such  statements,  so  far  as  they  relate  to  the  con- 
ditions which  preceded  the  Great  War,  cannot  seriously  be 
questioned.  Business  men  engaged  in  foreign  trade  have  dis- 
covered from  experience  that  the  commercial  long  bill,  drawn 
in  sterling  against  a  bank  in  London,  has  offered  the  most  con- 
venient and  the  cheapest  method  of  discharging  the  collec- 
tion and  financing  functions  required  to  complete  international 
mercantile  transactions.  Exporters  of  many  countries  have 
drawn  in  sterling  for  the  sale  price  of  goods  shipped  to  markets 
outside  of  England;  importers  in  these  markets  have  been 
required  to  cover  these  drafts  at  maturity  by  remittance  of 
sterling  demand  bills  to  London;  hence,  a  flood  of  commercial 
bills  arising  from  all  quarters  of  the  world  has  streamed  into 
the  London  market,  to  be  offset  by  a  corresponding  stream  of 
remittances,  the  two  currents  of  sterling  bills  being  cancelled 
against  each  other,  or  "cleared"  in  this  great  banking  center. 
Whether  or  no  the  economic  changes  wrought  by  the  Great 
War  will  leave  the  supremacy  of  London  undiminished,  that 
market  will  always  hold  a  position  of  such  importance  in  in- 
ternational trade  that  some  knowledge  of  its  mechanism  is 
essential  to  an  understanding  of  the  business  of  foreign  ex- 
change. In  the  discussion  which  follows,  we  shall  limit  our 
inquiry  to  those  features  of  the  London  market  which  are 
essentially  related  to  the  subject  of  foreign  exchange,  avoiding 
as  far  as  possible  the  technicalities  of  the  banking  business 
in  its  domestic  aspects.   ^ 


314  FOREIGN  EXCHANGE 

71.  Correspondent  relations  between  London  and  foreign 
banks.  Tlie  drawiui^  of  commercial  and  bankers'  sterling  bills 
ill  the  markets  of  the  world  implies  that  banks  in  those  mar- 
kets have  established  certain  connections  with  London.  These 
connections,  in  many  cases,  are  created  by  the  estaljlishment 
in  London  of  branch  banks  of  the  parent  institution  in  the 
foreign  market,  but  the  necessary  relation  is  much  more  fre- 
quently the  product  of  correspondent  agreements  drawn  up  be- 
tween independent  banks  in  the  two  centers.  A  large  share 
of  the  foreign  business  handled  by  the  great  incorporated  or 
private  banks  of  London  arises  from  these  correspondent 
agreements,  agreements  which  have  the  effect  of  making  the 
London  bank  either  a  partner  or  an  agent  of  the  foreign  bank 
in  transactions  which  involve  the  two  markets.  Each  in- 
stitution remains  distinct  in  ownership  and  control,  each 
free  to  seek  a  profit  from  the  business  of  its  domestic  market 
in  any  manner  pleasing  to  itself;  they  are  united  only  for  the 
purpose  of  mutual  profit  from  the  handling  of  certain  inter- 
national transactions  upon  terms  laid  down  by  the  contract 
which  they  form  with  each  other. 

Closer  bonds  of  union  between  London  and  foreign  centers 
are  formed  when  branches  of  the  same  banking  institution, 
operating  under  a  common  ownership  and  control,  are  founded 
in  the  two  markets.  Viewed  from  the  standpoint  of  London, 
these  branch  banks  fall  into  two  divisions:  London  offices  of 
colonial  banks  —  that  is,  branches  of  the  great  central  banks  of 
Australia,  Canada,  New  Zealand,  and  other  parts  of  the 
British  Empire  outside  the  United  Kingdom;  and  London 
offices  of  foreign  banks,  comprising,  before  the  Great  War, 
approximately  fifty  branches  of  banking  institutions  of  Amer- 
ica, Asia,  and  Europe  not  embraced  within  the  British  Empire. 
The  relations  formed  between  home  offices  and  their  London 
branches  cannot  strictly  be  called  correspondent  relations, 
since  the  two  institutions  are  in  each  case  organicallj^  united 
and  their  operations  are  controlled  from  a  common  center  and 
for  a  common  profit.  Yet,  in  practice,  the  branch  bank  has 
been  managed  under  a  separate  system  of  accounts  which  has 
caused  its  transactions  with  the  parent  institution  to  assume 


THE  EXCHANGE  MARKET— LONDON  S15 

the  appearance  of  relations  between  separate  firms,  and  these 
transactions  have  been  carried  on  upon  terms  and  by  methods 
closely  resembling  those  of  independent  banks. 

To  understand  the  relationships  created  by  a  correspond- 
ent agreement,  it  is  necessary  to  inquire  for  what  purposes 
a  bank  outside  of  England  seeks  to  establish  connections  with 
London,  for  the  agreement  will  be  so  framed  as  to  fulfill  these 
purposes.     Our  previous  discussion  has  shown  us  that  the 
foreign  bank  seeks  power  to  do  certain  things:  (a)  to  buy 
sterling  commercial  bills,  or  to  take  such  bills  for  collection, 
turning  them  over  to  the  London  agent  for  negotiation  in 
England;    (6)  to  draw  sterling  demand   drafts  for  sale  to 
its  clients;  (c)  to  secure  the  service  of  the  London  bank  as 
acceptor  for  sterling  bills,  drawn  either  by  the  foreign  bank 
or  by  some  other  individual  under  the  authority  of  a  letter  of 
credit  issued  by  the  foreign  bank.  Now,  there  is  an  essential 
distinction  between  the  power  required  to  perform  the  first 
two  of  these  groups  of  transactions,  and  that  required  to 
perform  the  third.     When  a  New  York  banker  buys  sterling 
commercial  bills  or  takes  such  bills  for  collection,  and  when 
he  sells  his  own  sterling  demand  drafts,  he  operates  on  the 
basis  of  a  cash  balance  maintained  in  London;  the  commercial 
bills  will  cause  an  inflow  of  funds  to  be  credited  to  this  bal- 
ance by  his  London  correspondent,  and  the  demand  drafts 
will  be  redeemed  out  of  these  funds.  Consequently,  to  carry 
on  the  transaction  included  in  groups  (a)  and  (6),  the  New 
York  banker  must  establish  and  maintain  a  foreign  balance, 
and  must  engage  the  services  of  a  London  l>anker  as  agent  for 
the  management  of  this   balance,  crediting  it  with  certain 
items,  charging  it  with  others,  and  informing  the  New  York 
banker  of  its  condition  at  intervals. 

But  the  third  group  of  transactions  cannot  be  carried  on 
upon  the  basis  of  a  foreign  balance  alone.  Sterling  long  bills 
drawn  for  acceptance  by  the  London  banker,  whether  they  be 
finance  bills  drawn  by  the  New  York  banker  himself  or 
commercial  bills  drawn  under  a  letter  of  credit,  will  be  carried 
by  the  London  correspondent  as  a  liability  of  the  New  York 
banker,  not  charged  to  the  foreign  balance  until  they  mature 


310  FOREIGN  EXCHANGE 

many  days  after  acceptance.  During  the  interval  between  ac- 
ceptance and  maturity,  these  hills  must  he  accounted  for  in 
such  a  way  as  to  disclose  clearly  the  nature  of  the  relationship 
between  the  two  correspondents  which  has  been  caused  by 
them,  and  this  requires  the  opening  of  an  acceptance  account. 
The  agreement  which  a  New  York  banker  forms  with  his  Lon- 
don correspondent,  in  order  to  answer  completely  all  of  his 
purposes,  must,  therefore,  cover  the  details  of  both  the  foreign 
balance  and  the  acceptance  account.  Ultimately,  of  course, 
the  acceptance  account  will  be  brought  to  bear  upon  the  for- 
eign balance;  for  all  acceptances  made  by  the  London  agent 
on  behalf  of  the  New  York  banker  will  be  redeemed  from  the 
latter 's  foreign  balance,  and  in  preparation  for  these  charges 
the  New  York  banker  must  make  a  remittance  of  cash  items 
before  the  acceptances  mature.  Thus  the  entire  volume  of 
bills  handled  under  the  acceptance  agreement  will  ultimately 
pass  through  the  foreign  balance. 

72.  The  foreign  balance.  The  amount  of  money  which  can 
usefully  be  kept  on  deposit  in  London  varies  rather  widely  for 
different  American  banks.  Like  all  other  phases  of  its  busi- 
ness, any  bank  engages  in  exchange  operations  for  the  purpose 
of  gaining  a  profit,  and  is  governed  in  the  details  of  its  trans- 
actions by  the  rules  of  business  efficiency.  The  size  and  char- 
acter of  its  clientele  must  determine  how  profitable  are  the 
services  made  possible  by  the  investment  of  a  part  of  its  capital 
in  a  foreign  balance,  and,  therefore,  how  large  this  investment 
should  be.  Naturally,  the  concern  of  the  bank  will  be  to  op- 
erate on  the  minimum  balance  commensurate  with  its  needs; 
and,  having  determined  what  this  minimum  is,  to  maintain 
the  balance  at  this  figure  as  nearly  as  possible  from  day  to  day. 
This  can  be  done  only  by  so  marshaling  the  credit  and  debit 
items  which  pass  through  the  hands  of  the  London  correspond- 
ent that  they  will  approximately  offset  each  other  over  brief 
periods  of  time.  If  the  supply  of  commercial  bills  sent  over 
for  credit  to  the  balance  is  unduly  large  at  any  time,  a  correc- 
tion will  be  made  by  selling  demand  drafts  or  cables  to  ex- 
haust these  excess  funds;  if,  on  the  other  hand,  the  charges 
against  the  balance  by  reason  of  the  maturity  of  acceptances 


THE  EXCHANGE  MARKET  — LONDON  S17 

fn  large  amounts  tend  to  draw  it  down  too  far,  the  American 
bank  will  buy  demand  drafts  or  cables  in  the  open  market 
and  send  them  over.  In  connection  with  these  various  opera- 
tions, the  London  correspondent  will  be  called  upon  daily  to 
perform  a  number  of  services  for  the  American  bank,  chief 
among  which  are  the  following: 

(a)  To  receive  all  commercial  bills  sent  over,  obtaining 
acceptances  upon  them,  discounting  them  in  the  money 
market,  or  collecting  them  at  maturity,  and  crediting 
the  balance  with  the  proceeds. 
(6)  To  care  for  the  documents  which  usually  accompany 
the  bills;  arranging  for  the  surrender  of  bill  of  lading 
under  terms  of  a  trust  receipt,  or  otherwise;  attending 
to  the  warehousing  of  the  goods  if  this  is  necessary; 
and  enforcing  the  performance  of  the  importer's  ob- 
ligations as  laid  down  by  the  terms  of  sale. 

(c)  To  receive  from  the  American  bank  by  mail  or  cable 
demand  drafts  on  other  London  banks;  to  send  these 
through  the  clearing  house,  or  collect  them  by  runner; 
and  to  credit  the  foreign  balance  with  the  proceeds. 

(d)  To  cash  across  its  counter  traveler's  checks;  checks 
drawn  under  a  traveler's  letter  of  credit;  and  sterling 
demand  drafts  and  cables  sold  on  this  side,  charging  the 
balance  with  these  expenditures. 

(e)  To  redeem  all  mature  acceptances  of  sterling  long  bills 
drawn  against  it  by  the  American  bank  or  under  letter 
of  credit  issued  by  that  bank,  debiting  the  balance 
with  the  amount. 

(/)  To  perform  a  number  of  incidental  services,  such  as 
investing  any  surplus  funds  in  securities  at  the  order  of 
the  American  bank;  selling  such  securities  when  so 
instructed  and  crediting  the  balance  with  the  proceeds; 
receiving  and  sending  shipments  of  gold;  making  re- 
mittances on  behalf  of  the  American  bank  to  neigh- 
boring cities,  buying  all  necessary  revenue  stamps  for 
the  documents  handled  and  charging  their  cost  to  the 
balance. 

The  agreement  drawn  up  between  the  two  bankers  must 


818  FOREIGN  EXCHANGE 

provide  for  the  discharge  of  all  these  services  and  for  the  cora- 
pensation  to  be  given  for  them.  We  shall  return  to  the  sub- 
ject of  compensation  a  little  later. 

Besides  arranging  for  the  performance  by  the  London  bank 
of  the  different  services  outlined  above,  the  correspondent 
agreement  will  usually  contain  some  stipulation  concerning 
the  amount  of  the  balance  to  be  maintained  and  the  interest 
to  be  paid  on  this  deposit.  It  is  the  frequent  practice  to  set 
a  minimum  below  which  it  is  understood  the  American  banker 
will  not  allow  his  balance  to  fall,  but  the  figure  is  viewed  more 
as  an  average  than  an  absolutely  rigid  lower  limit  to  the  bal- 
ance. In  certain  cases,  however,  and  especially  if  the  two 
institutions  have  had  a  long  and  profitable  association  with 
each  other,  no  minimum  at  all  is  set,  the  London  bank  re- 
lying upon  the  good  business  sense  of  its  American  corre- 
spondent to  maintain  a  sufficient  deposit  to  meet  all  normal 
requirements.  Under  such  conditions,  also,  it  is  not  unusual 
to  allow  overdrafts,  the  American  bank  being  charged  with 
interest  upon  that  portion  of  the  draft  covered  by  the  funds  of 
the  London  correspondent.  But  these  are  not  typical  cases; 
usually  the  agreement  will  bind  the  American  bank  to  keep  on 
deposit  a  certain  amount  of  cash  funds  from  day  to  day,  and 
daily  advice  will  be  sent  it  as  to  the  size  of  the  deposit  in  order 
that  it  may  govern  itself  accordingly. 

With  regard  to  the  payment  of  interest  by  the  London  cor- 
respondent, the  practice  again  varies.  Where  a  minimum  bal- 
ance is  required  by  the  terms  of  the  correspondent  agreement, 
it  is  usually  stipulated  that  interest  shall  be  paid  only  on  that 
portion  of  the  deposit  which  is  a  surplus  over  and  above  this 
minimum;  where  no  minimum  is  required,  interest  is  ordina- 
rily allowed  on  the  entire  balance,  or  on  the  daily  average. 
This  appears  to  be,  and  is,  an  unequal  treatment  of  the  two 
classes  of  American  banks,  for  in  the  one  case  the  London 
bank  is  allowed  the  use  of  a  certain  sum  of  money  without  in- 
terest charge,  while  in  the  other  any  profit  made  from  the 
balance  must  be  derived  from  a  diff^erence  between  the  rate  of 
interest  allowed  the  American  bank  and  the  rate  at  which  the 
balance  can  be  employed  in  the  London  money  market. 


THE  EXCHANGE  MARKET  —  LONDON  S19 

However,  some  compensation  is  usually  made  for  this  ine- 
quality by  the  practice  of  allowing  those  banks  which  have  the 
harder  terms  in  regard  to  the  interest  payment  a  somewhat 
lower  scale  of  commission  charges  on  the  services  rendered  by 
the  London  correspondent. 

Whatever  the  agreement  as  to  the  proportion  of  the  balance 
which  shall  be  interest-bearing,  the  rate  paid  is  the  same  for 
all  banks.  It  is  set  at  a  common  point  by  the  practice  of  the 
money  market  of  London,  and  called  the  deposit  allowance  rate. 
In  normal  times,  the  deposit  allowance  rate  is  fixed  one  per 
cent  below  the  published  discoimt  rate  of  the  Bank  of  England, 
but  this  relation  between  the  two  rates  cannot  be  expressed  as 
a  hard-and-fast  rule,  for  the  reason  that,  although  the  Bank  of 
England  rate  rises  to  high  figures  in  times  of  money  strin- 
gency, the  deposit  allowance  rate  does  not  rise  above  four  per 
cent,  except  in  rare  instances.  We  may  say  that,  when  the 
Bank  of  England  rate  stands  at  five  per  cent  or  below,  the  de- 
posit allowance  rate  will  be  one  per  cent  lower;  but,  when  the 
former  raises  above  five  per  cent,  the  latter  will  probably  re- 
main at  four  per  cent. 

73.  The  acceptance  account.  We  have  already  discussed, 
at  different  points  in  the  preceding  pages,  the  terms  usually 
agreed  upon  by  the  two  correspondent  banks  to  govern  the 
acceptance  account,  and  need  do  no  more  here  than  bring  this 
information  together  in  a  convenient  summary.  The  pur- 
pose of  the  acceptance  account  is  to  engage  the  services 
of  a  London  bank  as  acceptor  of  bills  which  it  is  the  duty  of 
the  American  bank  to  redeem  at  maturity;  accordingly,  the 
agreement  between  the  two  banks  will  be  such  as  to  subserve 
this  purpose.  The  London  bank  agrees  to  do  the  following 
things : 

(a)  To  accept  all  sterling  long  bills  drawn  by  the  American 
bank  or  under  its  authority,  provided  it  has  received 
advance  notice  of  the  drawing.  A  limit  is  usually 
set  to  the  amount  of  the  acceptances  which  may  be  out- 
standing at  a  given  time,  though,  in  rare  cases,  the 
maximum  is  left  entirely  to  the  discretion  of  the  Amer- 
ican bank. 


820  FOREIGN  EXCHANGE 

{!))  To  redeem  these  aeceptaiices  as  they  mature,  out  of  the 
balance  of  the  American  bank. 

(c)  To  handle  all  documents  which  may  accompany  these 
bills  under  instructions  from  the  American  bank. 

(d)  To  send  out  a  formal  confirmation  notice  to  the  bene- 
ficiary of  a  letter  of  credit,  when  so  instructed. 

For  its  part,  tlie  American  bank  is  bound  to  perform  the 
following  duties: 

(a)  To  advise  the  London  correspondent  in  advance  on 
each  occasion  of  the  drawing  of  a  sterling  long  bill  for 
acceptance,  or  the  issuing  of  a  letter  of  credit  which 
empowers  another  party  to  draw  them. 

(b)  To  make  advance  deposits  to  the  credit  of  its  cash  bal- 
ance in  time  to  redeem  all  acceptances. 

(c)  To  supply  collateral  security,  usually  in  the  form  of 
first-class  stocks  or  bonds,  to  the  amount  of  the  max- 
imum to  which  it  is  allowed  to  draw  against  the  accept- 
ance account.  This  provision  has  the  effect  of  guaran- 
teeing the  performance  by  the  American  bank  of  its 
obligation  to  redeem  the  acceptances.  The  deposit  of 
collateral  is  not  always  required,  but  the  cases  where 
it  is  waived  are  the  exception  to  the  rule. 

The  acceptance  account,  itself,  is  a  bookkeeping  device  for 
recording  the  liabilities  of  the  American  bank  on  account  of 
acceptances  performed  by  the  London  correspondent.  As 
each  sterling  bill  is  presented  for  acceptance,  its  amount  and 
the  date  of  maturity  will  be  recorded  as  a  charge  to  the  ac- 
ceptance account;  usually,  also,  a  duplicate  of  the  bill  will  be 
kept  in  the  portfolio  of  the  bank.  As  the  acceptance  matures 
and  is  presented  for  encashment,  it  is  paid  from  the  cash  bal- 
ance of  the  American  bank  and  the  amount  removed  from  the 
acceptance  account  by  recording  a  credit.  At  any  given  time, 
therefore,  the  balance  of  the  acceptance  account  will  disclose 
the  number  of  acceptances  outstanding  and  the  dates  upon 
which  they  mature;  thus  exhibiting  the  liability  of  the  Amer- 
ican bank  for  future  remittances  of  cash  items  as  cover  for 
the  acceptances.  If  duplicates  are  kept,  these  are  arranged  in 
the  portfolio  according  to  maturities  so  as  to  show  at  a  glance 


THE  EXCHANGE  MARKET  — LONDON  321 

the  total  number  of  bills  which  the  American  bank  is  obligated 
to  redeem  at  certain  future  dates.  As  has  been  said,  the  Lon- 
don bank  in  most  cases  stipulates  that  the  value  of  the  accept- 
ances outstanding  must  not  exceed  a  certain  maximum  at 
any  given  time.  The  exact  amount  of  this  maximum  is 
usually  determined  with  reference  to  the  average  cash  bal- 
ance which  it  is  the  custom  of  the  American  bank  to  keep,  for 
it  is  upon  the  sufficiency  of  this  balance  that  the  London  bank 
depends  for  its  ability  to  redeem  the  acceptances  at  maturity. 
The  maximum  is  of  the  nature  of  a  "revolving  fund  ";  that  is, 
as  acceptances  are  retired,  their  amount  becomes  once  more 
available  for  the  drawing  of  sterling  bills  by  the  American 
bank,  but  when  the  maximum  credit  has  been  reached,  draw- 
ing must  stop  until  some  of  the  outstanding  acceptances  have 
reached  their  term. 

74.  Commission  charges  of  London  correspondent  banks. 
A  London  correspondent  may  possibly  derive  an  income  by 
employing  the  cash  balance  at  a  higher  rate  of  interest  than  the 
allowance  rate  granted  the  depositing  banker.  Furthermore, 
it  may  have  in  its  possession  a  certain  amount  of  cash  funds 
upon  which  no  interest  is  paid  and  may  derive  a  profit  from 
this  addition  to  its  supply  of  working  capital.  In  the  main, 
however,  it  is  not  upon  these  sources  of  profit  that  the  London 
bank  relies  for  its  remuneration  for  the  services  rendered  its 
foreign  correspondents,  but  upon  a  predetermined  schedule 
of  commission  charges  to  which  both  bankers  have  agreed. 
There  is  little  uniformity  in  this  scale  of  commissions.  In 
some  cases  the  commission  principle  is  discarded  entirely, 
and  the  American  bank  is  charged  a  certain  annual  fee  pro- 
portional to  the  amount  of  business  expected;  but  this  is  rare. 
When  the  remuneration  is  determined  by  the  commission 
principle,  the  agreement  may  take  either  of  two  forms :  (a)  a 
flat  percentage  charge  on  all  business  passing  through  the  hand 
of  the  London  bank;  (6)  a  list  of  services  for  which  commission 
will  be  charged,  together  with  a  percentage  charge  peculiar 
to  each  kind  of  service.  In  the  first  case,  the  amount  charged 
will  vary  inversely  with  the  volume  of  business,  thus  giving 
preferential  treatment  to  the  larger  correspondents.     The 


322  FOREIGN  EXCHANGE 

average  rate  is  probably  about  1/8  of  one  per  cent;  but  this 
averaiJje  lias  little  sij^nificance  for  the  rate  is  sometimes  set  as 
high  as  1/4  per  cent,  and  sometimes  as  low  as  1/32  per  cent. 
Under  the  second  method  of  determining  the  commission 
charged  by  the  London  correspondent,  the  services  for  which 
a  charge  is  made  are  the  following: 
(a)  The  acceptance  of  bills  for  the  American  bank.  The 
commission  is  adjusted  to  the  life  of  the  acceptance, 
being  stated  as  a  percentage  of  its  value  per  month  of 
its  life.  The  act  of  acceptance  makes  the  bill  the  legal 
obligation  of  the  London  bank  regardless  of  perform- 
ance or  non-performance  by  the  American  bank  of  its 
duty  to  supply  the  funds  for  its  redemption.  In  a 
sense,  therefore,  the  accepting  bank  is  risking  its  funds 
against  the  chance  of  insolvency  of  its  correspondent, 
or  of  financial  disturbance  in  the  correspondent's  mar- 
ket which  may  render  the  correspondent  temporarily 
unable  to  perform  its  part  of  the  acceptance  agreement. 
This  risk  is  to  some  extent  dependent  upon  the  length 
of  life  of  the  acceptance;  hence,  the  practice  of  propor- 
tioning the  commission  charge  to  the  usance  of  the  bills. 
The  percentage  varies  for  different  banks,  but  is  usually 
either  I/8  or  I/I6  per  cent  per  month.  It  should  be 
understood  that  this  charge  applies  to  bills  drawn  by  the 
American  bank  as  well  as  to  those  drawn  by  foreign 
exporters  under  the  authority  of  a  sterling  letter  of 
credit. 
(6)  The  caring  for  documents  attached  to  commercial  biUs 
of  all  kinds.  These  documents  must  be  examined  to 
determine  whether  they  conform  to  the  instructions  of 
the  draft,  and  then  be  detached  and  delivered  to  the 
drawee  either  upon  acceptance  or  upon  payment  or  pre- 
payment. In  many  cases,  the  American  bank  allows  the 
correspondent  freedom  to  use  its  discretion  in  handling 
the  documents,  though,  more  frequently,  it  is  under- 
stood that  the  London  bank  will  act  only  under  orders. 
Caring  for  the  documents  involves  the  drawing  up  of 
trust  receipts,  the  warehousing  of  goods,  and  many  other 


THE  EXCHANGE  MARKET  — LONDON  323 

details  which  may  become  necessary  when  goods  are 
imported  into  England.  The  rate  charged  is  usually 
very  small.  Perhaps  1/32  per  cent  on  the  face  of  the 
bill  is  a  typical  rate. 

(c)  The  disposal  of  merchandise  seized  because  of  default 
on  the  part  of  the  drawee  of  the  commercial  bills.  It 
will  be  recalled  that  the  American  bank  in  buying  a 
commercial  bill  is  given  first  lien  upon  the  goods  as 
collateral  security  against  failure  of  the  importer  to 
redeem  the  draft.  The  buying  bank  will  not  place  great 
reliance  upon  this  collateral  because  of  the  bothersome 
and  expensive  transactions  necessarily  connected  with 
the  sale  of  wares  by  an  institution  for  whom  commercial 
operations  are  foreign  to  its  business;  and  the  seizure 
of  the  goods  will  not,  in  any  case,  release  the  drawer 
from  his  liability  to  make  good  any  loss  on  the  bill.  When 
necessary,  however,  the  seizure  of  the  goods  will  be 
accomplished  by  the  London  correspondent,  who  will 
await  further  instructions  before  proceeding  with  the 
sale.  The  American  bank  will  then  communicate  with 
the  drawer  of  the  bill,  allowing  him  the  choice  of  having 
the  goods  returned  at  his  expense  or  of  attempting 
another  sale  in  the  English  market.  If  neither  of  these 
alternatives  is  adopted,  the  London  correspondent 
will  be  instructed  to  sell  the  shipment,  the  usual  method 
of  procedure  being  to  turn  the  entire  lot  over  to  some 
broker  to  be  disposed  of  at  the  best  terms  available  in 
the  market.  The  brokerage  charges  will  be  paid  out  of 
the  American  bank's  balance  and  added  by  the  latter 
to  the  amount  which  it  recovers  from  the  drawer  of  the 
dishonored  draft.  The  commission  of  the  London 
bank  is  separate  from  these  brokerage  charges;  again, 
the  rate  cannot  be  stated  definitely,  though  a  charge  of 
l/lG  per  cent  is  not  uncommon. 

(d)  Confirmation  of  a  letter  of  credit  or  of  any  bank  credit. 
The  act  of  confirmation  will  not  be  performed  unless  posi- 
tive instructions  are  received  from  the  American  l)aiik 
to  that  effect.    The  confirmation  increases  the  liability 


324  FOREIGN  EXCHANGE 

of  the  London  acceptor,  since  it  gives  the  beneficiary 
of  the  letter  of  credit  the  legal  right  to  exact  the  per- 
formance of  accei)tance  on  all  bills  drawn  in  conformity 
with  the  terms  of  the  letter  of  credit;  without  confirma- 
tion, the  liability  of  the  London  bank  would  lie  solely 
between  itself  and  the  American  correspondent.     A 
charge  is  properly  made  for  the  increased  liability  caused 
by  the  confirmation,  and  this  expense  is  passed  on  by  the 
American  bank  to  its  client  in  the  form  of  a  higher 
charge  for  a  confirmed  than  for  an  unconfirmed  letter 
of  credit.     The  commission  for  confirmation  is  usually 
about  1/8  per  cent  of  the  face  of  the  bill,  though  this  rate, 
like  all  others,  varies  widely  between  different  banks. 
(e)  The  cashing  of  drafts  drawn  under  a  traveler's  letter  of 
credit  and  of  travelers'  checks  in  case  these  are  issued 
with  fixed  conversion  rates  upon  their  face.    The  checks 
are,  or  course,  redeemed  out  of  the  cash  balance  of 
the  American  correspondent.    A  charge  is  not  always 
made  for  this  service,  and  where  made  is  at  a  very  low 
rate,  something  like  1/32  per  cent. 
75.  The  London  discount  market.     The  correspondent 
relations  just  discussed  are  sought  by  American  banks  and  the 
banks  of  other  countries  so  that  they  may  be  enabled  to 
conduct  certain  operations  in  sterling  exchange,  operations 
made  profitable  by  the  commanding  position  enjoyed  by  ster- 
ling bills  in   all  the   exchange  markets  of  the  world.     One 
powerful  factor  making  for  this  supremacy  of  sterling  ex- 
change has  been  the  ease  with  which  long  bills  have  been 
discounted  after  acceptance  in  the  money  market  of  London. 
In  many  of  the  transactions  carried  on  by  the  correspondents 
of  London  banks,  the  discounting  of  the  sterling  bill  is  an 
essential  step,  so  essential,  in  fact,  that  the  transaction  would 
fail  of  its  purpose  if  the  discounting  of  the  bill  should  prove 
impossible. 

For  example,  the  finance  bill  drawn  by  an  American  bank 
and  accepted  by  its  London  correspondent  is  created  for  the 
sole  purpose  of  enabling  the  drawee  to  make  a  short-term 
loan  in  the  New  York  market;  it  is,  however,  foreign  to  the 


THE  EXCHANGE  MARKET  — LONDON  325 

intention  of  the  two  correspondents  that  either  of  them  bear 
the  burden  of  this  advance,  for  the  finance  bill  will  be  dis- 
counted immediately  upon  acceptance,  and  so  absorb  a  part 
of  the  loan  funds  of  the  London  market.  Similarly,  all  the  ne- 
gotiations which  lead  up  to  the  drawing  of  a  sterling  long  bill 
under  a  commercial  letter  of  credit  hinge  upon  the  discounting 
of  this  bill  in  London.  The  exporter  is  to  receive  his  money 
as  soon  as  his  goods  are  shipped;  the  importer  is  not  to  pay 
until  a  later  date;  neither  of  the  correspondent  banks  in- 
volved in  the  issue  of  the  letter  of  credit  contemplates  making 
the  advance  of  funds  which  this  situation  implies.  But  there 
are  lenders  of  money  in  the  discount  market  of  London  willing 
to  advance  funds  to  finance  just  such  transactions  as  this,  and 
the  exchange  operations  are  calculated  to  create  a  credit  in- 
strument which  makes  these  funds  available  for  the  use  of  the 
two  merchants. 

In  brief,  it  may  be  said  that,  whenever  a  sterling  bill  of 
exchange  is  expected  to  discharge  a  financing  function,  the 
discount  market  of  London  is  essential  to  the  consumma- 
tion of  its  purpose,  excepting  those  transactions  in  which  it 
is  the  intention  of  the  banker  who  buys  the  bill  from  the 
drawer  to  retain  it  as  an  investment.  In  these  cases,  it  is 
the  buying  banker  who  chooses  to  make  the  advance  of  funds, 
and  he  will  hold  the  accepted  bill  off  the  discount  market  in 
order  to  obtain  for  himself  the  increase  in  value  which  will 
accrue  as  maturity  is  reached.  But  it  is  obvious  that  the 
banker  will  not  choose,  in  this  manner,  to  invest  in  a  sterling 
long  bill  unless  loan  funds  are  cheaper  in  his  own  market  than 
they  are  in  London,  for  the  bill  will  earn  interest  at  the  Lon- 
don rate,  and,  unless  this  rate  is  the  higher  of  the  two,  the 
banker  will  be  choosing  the  less  profitable  of  two  alternative 
uses  for  his  funds.  Since  it  is  rarely  true  that  the  London 
discount  rate  rises  above  that  of  other  financial  centers,  by 
far  the  greater  proportion  of  sterling  long  bills,  bought  by 
the  exchange  bankers  of  other  markets,  are  sold  in  the  open 
market  of  London  after  acceptance  has  been  secured  upon 
them. 
A  few  words  in  further  description  of  these  bills  in  which  the 


S<IG  FOREIGN  EXCHANGE 

discount  market  of  London  deals.  Tliey  are,  of  course,  always 
acceptances,  for  a  bill  of  exchange  unaccepted  has  not  yet 
acciuired  the  character  of  a  bindinj?  obligation  of  the  drawee 
and  so  has  slight  investment  value.  Furthermore,  they  are, 
for  the  most  part,  the  acceptances  of  l)anks  or  finance  houses. 
The  reason  for  this  has  been  disclosed  in  our  discussion  of 
sterling  commercial  long  bills.  Trade  bills,  the  acceptances 
of  merchants,  are  in  the  majority  of  cases  taken  by  the  bankers 
for  collection  onlj%  and  do  not  represent  an  advance  of  funds 
to  the  exporter,  since  they  are  not  discounted  at  any  stage  of 
their  existence.  Those  trade  bills  which  are  bought  by  the 
bankers  are  almost  always  documented,  and  carry  the  in- 
structions, documents  against  payment.  Since  these  bills 
cannot  be  separated  from  their  documents  if  they  are  dis- 
counted in  the  open  market,  they  make  a  credit  instrument 
somewhat  difficult  to  handle.  But  the  most  effective  bar  to 
the  discounting  of  payment  bills  is  the  acceptor's  privilege  of 
prepayment  at  any  time  before  maturity,  a  privilege  made 
operative  by  the  custom  of  the  London  market  against  any 
holder  of  the  acceptance.  The  enforcement  of  this  privi- 
lege requires  a  record  of  the  history  of  the  acceptance,  and 
this  involves  in  a  system  of  red  tape  any  attempt  to  transfer 
the  bills  from  hand  to  hand  in  the  open  market;  moreover, 
an  investor  in  them  is  always  in  doubt  as  to  the  date  of  ma- 
turity of  his  assets.  For  these  reasons  they  are  not  dis- 
counted. 

We  have  thus  eliminated  all  trade  bills  taken  for  collection 
and  all  payment  bills;  there  remains  only  that  small  portion 
of  trade  bills  which  are  drawn  against  houses  of  the  highest 
international  reputation  and  carry  the  instructions,  documents 
against  acceptance.  These  are  bought  by  bankers  and  are 
discounted  in  the  London  market.  Bankers'  acceptances 
and  the  acceptances  of  these  merchants  of  superior  credit 
rating,  all  of  them  clean  bills,  comprise  the  exchange  instru- 
ments in  which  the  London  discount  market  deals.  We  shall 
now  proceed  to  examine  the  mechanism  of  this  market  in  its 
relations  to  the  business  of  foreign  exchange.  Its  agencies  fall 
into  four  divisions  (a)  the  private  and  incorporated  banks  of 


THE  EXCHANGE  MARKET  — LONDON    327 

London,  including  the  London  offices  of  foreign  banks;  (6) 
the  bills  brokers;  (c)  the  discount  houses;  (d)  the  Bank  of 
England. 

76.  Relation  of  the  London  banks  to  the  discount  market. 
The  commercial  banks  of  London  hold  a  twofold  relation  with 
the  discount  market,  being  at  the  same  time  the  greatest  source 
of  supply  of  acceptances  for  the  other  money-lenders,  and 
themselves  the  discounters  of  a  part  of  this  supply  of  accept- 
ances. As  correspondents  of  foreign  banks,  it  is  an  ordinary 
phase  of  their  business  to  receive  sterling  bills  from  all  quarters 
of  the  world,  present  them  for  acceptance  to  their  drawees,  and 
offer  them  for  sale  in  the  discount  market.  The  bill  brokers  and 
other  dealers  in  the  open  market  find  in  this  continuous 
stream  of  acceptances  an  immense  field  of  investment  oppor- 
tunity, and  they,  accordingly,  depend  upon  the  banks  for  daily 
supplies  of  commercial  paper  which  they  may  buy  and  hold 
until  maturity.  But  the  banks  themselves  are  primarily 
credit  institutions,  whose  normal  function,  hke  that  of  the 
banks  of  discount  and  deposit  in  America,  is  to  lend  cash  and 
credit  on  the  security  of  commercial  paper  of  all  sorts.  The 
accepted  bill  of  exchange,  as  a  credit  instrument,  possesses 
elements  of  superior  attractiveness.  It  is  usually  drawn  for 
a  short  term;  its  security  is  of  the  best,  especially  when  the 
acceptor  is  a  bank;  and  it  enjoys  a  broad  market  in  which  it 
can  be  easily  resold  in  case  of  emergency.  Consequently,  it 
appeals  to  bankers  whose  assets  must  be  both  secure  and  hquid, 
and  so  it  is  not  at  all  strange  that  a  large  part  of  the  accept- 
ances which  pour  into  the  London  money  market  should  be 
taken  up  by  the  bankers  themselves  and  carried  for  their  own 
account. 

The  bills  of  exchange  bought  by  the  London  bankers  are 
drawn  principally  from  two  different  sources.  Li  the  first 
place,  these  banks,  as  correspondents  of  banks  in  other  cen- 
ters, are  daily  handling  a  mass  of  sterling  bills  sent  over  for 
acceptance  and  discount.  The  instructions  which  accompany 
these  bills  usually  require  that  the  acceptance  be  sold  imme- 
diately in  order  to  recover  the  money  invested  by  the  foreign 
bank  by  the  act  of  purchase.  Such  instructions  bind  the  Lon- 


828  FOREIGN  EXCHANGE 

don  correspondent  to  dispose  of  the  acceptance  and  credit  the 
cash  hahmce  of  the  foreijjn  bank  witli  the  proceeds,  but  leave 
hira  free  to  exercise  his  function  as  money-lender  and  buy  the 
acceptance  at  the  same  rate  of  discount  that  would  apply  to  it 
in  the  money  market.  Indeed,  one  of  the  advantages  which 
the  London  banker  derives  from  his  position  as  correspond- 
ent is  this  power  of  selection  over  a  great  variety  of  credit 
instruments  placed  in  his  hands  by  the  banks  of  many  foreign 
cities;  his  duty  demands  only  that  he  credit  his  foreign  client 
with  the  discomited  value  of  the  instrument,  leaving  him  free 
to  choose  for  his  own  uses  those  which  best  suit  his  purposes. 
The  second  source  of  supply  upon  which  these  banks  depend  is 
afforded  by  the  bill  brokers  of  the  market  who  act  as  middle- 
men among  the  bankers.  These  brokers  deal  with  the  London 
banks  both  as  buyers  and  as  sellers  of  acceptances,  investing 
in  those  acceptances  which  most  appeal  to  them  and  offering 
to  other  banks  a  wade  range  of  selection  over  the  different 
items  which  they  have  bought. 

It  is  essential  to  good  banking  practice  that  the  instruments 
which  comprise  the  bank's  assets  should  be  so  arranged  as  to 
provide  a  continuous  stream  of  maturities  from  day  to  day. 
This  end  will  not  be  achieved  without  conscious  manipulation 
of  the  commercial  paper  which  fills  the  bank's  portfolio; 
for,  otherwise,  gaps  are  sure  to  appear  between  the  maturities, 
causing  the  liquidation  of  credit  instruments  to  concentrate 
upon  certain  dates,  and  thas  impairing  the  liquidity  of  the 
assets  and  throwing  the  bank  open  to  the  risk  of  insufficiency 
of  cash  upon  the  days  when  few  maturities  occur.  The  bill 
brokers  provide  a  very  useful  offset  against  this  condition  by 
offering  the  bankers  daily  a  large  number  of  acceptances  of 
various  maturities  from  which  to  choose  those  which  fit  the 
needs  of  each  banker's  assets.  This  gives  the  bankers  oppor- 
tunity to  invest  their  excess  cash  in  such  a  way  as  to  improve 
the  liquidity  of  their  commercial  paper.  The  bankers'  buying 
price,  in  each  instance,  will  be  governed  by  the  ruling  rate  of 
discount  in  the  open  market  for  the  class  of  paper  in  question. 

77.  The  bill  brokers  and  discount  houses.  In  its  customary 
meaning  the  term  "broker"  signifies  an  individual  who  acts 


THE  EXCHANGE  MARKET— LONDON  329 

as  go-between  bringing  buyer  and  seller  together,  investing  no 
capital  of  his  own,  but  drawing  an  income  in  the  form  of  fee 
or  commission  for  his  services.  It  is  probable  that  the  bill 
brokers  of  the  London  discount  market  originally  performed 
only  this  function  of  go-between,  but  if  so,  they  have  in  recent 
years  lost  their  original  character  and  become  investors  on 
their  own  account.  The  brokers  and  the  discount  houses 
together  form  the  backbone  of  the  discount  market  of  London, 
absorbing  a  major  share  of  all  acceptances  which  enter  the 
market. 

The  bill  brokers  are  not  incorporated  banks,  but  private  in- 
dividuals operating  with  capital  a  large  part  of  which  they  bor- 
row for  short  terms  from  the  joint-stock  banks  of  the  market. 
They  limit  their  operations  almost  entirely  to  the  purchase 
and  sale  of  bills  of  exchange,  do  not  accept  deposits  or  lend 
upon  ordinary  commercial  paper,  but  take  up  the  acceptances 
which  the  London  banJks  offer  for  sale  and  hold  them  until 
maturity  or  resell  them  at  a  previous  date  if  it  becomes  ad- 
visable to  release  the  money  invested  in  them.  The  relation  of 
the  brokers  to  the  London  banks,  as  disclosed  in  the  preceding 
section,  is  somewhat  peculiar;  they  borrow  from  the  banks 
at  low  rates  and  for  short  terms  against  a  deposit  of  collateral 
made  up  of  "prime"  acceptances.  Government  bonds,  and 
other  first-class  credit  instruments;  they  then  buy  accepted 
bills  from  these  same  banks  with  the  money  they  have  bor- 
rowed from  them;  finally,  they  sell  back  to  the  banks  at  a 
more  favorable  rate  a  portion  of  the  acceptances  which  they 
have  bought  from  them.  Over  a  large  share  of  the  acceptances 
which  they  buy,  they  retain  permanent  ownership,  usually 
carrying  them  as  collateral  against  their  loans.  Whenever  it 
becomes  necessary  to  reduce  their  loans  at  the  bank,  they  re- 
discount these  acceptances,  passing  them  over  to  the  discount 
houses,  or  to  the  banks,  or,  finally,  to  the  Bank  of  England. 
By  these  operations,  they  build  up  a  broad  market  for 
accepted  bills  of  exchange,  and  their  presence  in  London  ac- 
counts in  large  measure  for  the  ease  with  which  that  market 
absorbs  the  immense  flood  of  sterling  bills  which  daily  pours 
into  it. 


530  FOREIGN  EXCHANGE 

The  coni{)loxity  of  the  relationship  between  the  London 
lianks  and  the  l)ill  brokers  requires  further  explanation.  In  all 
financial  centers,  the  hanks  carry  a  large  part  of  the  liquid 
reserves  of  the  outlyincj  country  districts,  reserves  which 
nuist  be  invested  carefully  so  as  to  allow  almost  immediate 
liquidation  in  case  any  emerjrency  requires  that  they  be 
turned  into  cash.  Loans  at  call  secured  by  negotiable  instru- 
ments of  the  highest  order  afford  the  most  eligible  method  of 
investing  such  funds.  In  New  York,  these  call  loans  have 
been  made  for  the  most  part  to  the  brokerage  houses  dealing 
on  the  Stock  Exchange  and  have  been  secured  by  the  stocks 
and  bonds  in  which  these  borrowing  houses  deal.  But  in 
London  the  practice  of  fortnightly  settlement  on  the  Stock 
Exchange  debars  most  operators  from  contracting  call  loans 
against  a  deposit  of  stocks  and  bonds.  This  releases  the  liquid 
funds  of  the  banks  for  the  use  of  bill  brokers  whose  collateral 
security  consists  in  the  main  of  the  instruments  in  which  they 
deal,  namely,  accepted  sterling  bills  of  exchange  maturing  at 
different  future  dates.  A  call  loan  so  secured  can,  in  normal 
times,  be  renewed  from  day  to  day  and  so  can  be  relied  upon 
to  supply  the  broker  with  the  funds  needed  to  carry  him 
through  a  prolonged  series  of  operations.  As  the  acceptances 
mature,  they  may  be  removed  from  the  collateral  deposit  and 
others  substituted  for  them,  thus  making  of  the  deposit  a  sort 
of  revolving  fund  into  which  may  be  placed  the  acceptances 
the  bill  broker  is  carrying  until  maturity,  and  from  which  may 
be  withdrawn  those  needed  for  redemption  or  rediscount.  In 
times  of  money  stringency,  however,  the  banks  call  in  these 
loans,  thus  forcing  the  brokers  to  rediscount  in  bulk  —  usually 
with  the  Bank  of  England  —  the  acceptances  which  have 
been  serving  as  collateral,  in  order  to  return  the  money  origi- 
nally borrowed.  In  addition  to  the  funds  raised  by  means  of 
call  loans,  the  bill  brokers  possess  a  working  capital  of  their 
own  which  supplies  them  with  a  number  of  acceptances  apart 
from  those  serving  as  collateral,  and  these  they  may  sell  when- 
ever a  favorable  opportunity  appears,  or  may  substitute  for 
those  in  the  collateral  fund  if  any  of  the  latter  better  serve  the 
requirements  of  their  customers. 


THE  EXCHANGE  MARKET  — LONDON  331 

The  long  experience  of  the  bill  brokers  equips  them  as  ex- 
perts to  analyze  the  qualities  of  the  various  grades  of  ster- 
ling acceptances  which  appear  in  the  London  market  and  to 
adjust  their  rates  of  discount  to  the  quality  of  the  bill  with 
great  precision  in  each  instance.  It  is  their  daily  business  to 
make  a  circuit  of  the  London  banks,  examine  the  acceptances 
offered  for  sale,  take  up  any  they  may  choose  to  buy,  and  at  the 
same  time  to  offer  to  each  banker  an  opportunity  to  purchase 
upon  stated  terms  any  bills  already  in  the  brokers'  portfolios. 
The  prices  offered  by  the  brokers  as  buyers  of  bills  establish 
the  ruling  rates  of  discount  for  the  London  market  as  a  whole; 
the  bills  are  classified  according  to  security  and  length  of  life, 
and  keen  competition  among  the  brokers  determines  for  each 
class  the  peculiar  rate  of  discount  which  it  will  command  in 
the  open  market.  The  entire  schedule  of  rates  coheres  about 
the  rate  for  "prime  bankers'  acceptances,"  and  this  may  be 
called  the  open  market  discount  rate  for  bills  of  exchange.  It  is 
this  governing  rate  to  which  reference  is  made  in  all  state- 
ments which  speak  of  the  rate  of  discount  in  the  London 
market;  in  reality,  instead  of  a  single  rate,  it  is  a  system  or 
schedule,  the  lowest  applying  to  prime  acceptances  of  bankers, 
the  others  ranging  higher  according  to  the  qualities  of  the  bills 
to  which  they  apply.  The  correction  of  this  schedule  of  rates 
from  day  to  day  is  left  to  the  free  competitive  action  of  the  bill 
brokers  and  discount  houses,  for  they  alone,  of  all  the  money- 
lenders in  the  market,  limit  their  activities  to  the  purchase 
and  sale  of  bills  of  exchange,  and  hence  through  them  the  play 
of  demand  and  supply  produces  a  rate  which  will  clear  the 
market. 

The  open  market  rate  of  discount  is  employed  by  the  bankers 
when  they  buy  for  their  own  account  any  of  the  bills  placed 
in  their  hands  by  the  bankers  of  foreign  cities;  hence,  these 
foreign  correspondents  can  rely  upon  receiving  the  same  prices 
for  their  bills  regardless  of  whether  the  buying  is  done  by 
their  London  agents  or  by  a  broker  in  the  open  market.  How- 
ever, when  acceptances,  bought  by  the  brokers,  are  resold  to 
the  banks,  it  is  the  practice  of  the  London  market  to  allow  a 
slightly  lower  rate  of  discount.    This,  of  course,  docs  not  mean 


53^  FOREIGN  EXCHANGE 

that  a  bank  will  buy  back  at  a  higher  price  a  bill  which  it 
has  itself  sold  to  a  broker,  but  virtually  the  same  result  is 
reached;  for  the  banks  which  have  sold  bills  to  the  brokers  at 
a  certain  rate  of  discount  will  buy  other  bills  on  the  same  day 
at  a  lower  rate.  To  illustrate,  a  given  broker  may  purchase 
from  a  bank  on  a  certain  day  an  acceptance  for  ten  thousand 
pounds  running  for  sixty  days  at  a  rate  of  4  per  cent,  and 
inmiediately  sell  the  same  acceptance  to  another  bank  at 
a  discount  of  3  3/4  per  cent.  The  broker's  buying  {)rice, 
determined  by  the  higher  rate  of  discount,  will,  of  course,  be 
lower  than  his  selling  price  determined  at  the  lower  rate.  The 
difference  in  the  brokers'  favor  between  the  rates  at  which  the 
banks  buy  and  sell  bills  when  dealing  with  them  is  not  always 
as  great  as  1/4  per  cent,  sometimes  falling  as  low  as  l/lG  per 
cent;  but  even  this  small  concession  is  sufficient  on  a  large 
turnover  to  produce  a  considerable  and  continuous  profit  for 
the  brokers. 

The  question  may  arise.  Why  do  the  bankers  thus  favor  the 
brokers  in  their  dealings  with  them?  The  reason  is  to  be  found 
in  the  fact  that  bills  of  exchange  in  passing  through  the  brokers' 
hands  gain  in  desirability  from  the  point  of  view  of  the  bankers, 
with  the  result  that  the  acceptances  which  the  banks  buy  from 
the  brokers  are  worth  more  than  those  which  they  sell.  The 
activities  of  the  brokers  increase  the  desirability  of  the  accept- 
ances in  which  they  deal  in  two  ways.  In  the  first  place,  the 
fact  that  a  banker  decides  to  sell  an  acceptance  rather  than  in- 
vest in  it  for  his  own  account  is  evidence  that  that  particular 
bill  does  not  fit  his  needs;  its  amount  may  be  too  large,  or  it 
may  bear  the  name  of  an  acceptor  whose  obligations  the  banker 
already  holds  to  an  extent  as  large  as  prudence  will  allow,  or 
its  date  of  maturity  may  not  fit  in  with  the  sequence  of  matur- 
ities in  his  portfolio.  The  acceptance  which  the  banker  buys 
from  a  broker  will  be  selected  with  all  these  requirements  in 
mind  and  will,  therefore,  be  a  more  attractive  investment 
instrument  and  worth  a  higher  price.  Viewed  from  this  stand- 
point, the  transactions  between  brokers  and  bankers  in  the 
market  as  a  whole  have  the  effect  of  passing  over  a  great  mass 
of  miscellaneous  bills  to  the  brokers,  to  be  assorted  and  redis- 


THE  EXCHANGE  MARKET  — LONDON  333 

tributed  among  the  bankers  according  to  the  requirements  of 
each.  This  is  a  distinctively  middleman's  function  and  is 
worth  the  remuneration  it  commands. 

There  is  a  second  reason  why  a  bill  of  exchange  grows  in  de- 
sirability as  a  credit  instrument  in  passing  through  the  brokers' 
hands.  Credit  instruments  are  ordinarily  transferred  by  en- 
dorsement from  one  holder  to  another,  the  act  of  endorsement 
adding  to  the  security  of  the  instrument  by  increasing  the 
number  of  contingent  guarantors.  Now,  the  bills  of  exchange 
which  are  sent  over  to  the  London  market  are  usually  en- 
dorsed in  blank  by  the  foreign  banker  who  buys  them  from  the 
drawer,  and  this  makes  them  transferable  without  further 
endorsement;  nevertheless,  it  is  the  practice  of  the  market  to 
require  some  form  of  endorsement  from  the  brokers  when 
these  bills  are  resold  by  them  to  the  banks.  This  endorse- 
ment is  not  often  placed  upon  the  acceptance  itself,  but  the 
same  end  is  reached  by  means  of  a  contract  given  by  the 
broker  to  each  banker  with  whom  he  rediscounts  bills,  guar- 
anteeing the  redemption  of  all  items  sold  by  the  broker  at 
any  time.  Consequently,  when  a  broker  sells  an  accept- 
ance its  security  is  somewhat  better  than  it  was  at  the  time 
he  bought  it,  and  the  bankers  may  properly  take  account  of 
this  fact  in  adjusting  the  rates  at  which  they  deal  with  the 
brokers. 

The  discount  houses  hold  a  place  in  the  London  market  very 
similar  to  that  of  the  bill  brokers;  both  make  it  their  principal 
business  to  discount  acceptances.  There  are,  however,  cer- 
tain distinctions  between  these  two  groups  of  money-lenders, 
both  in  function  and  in  form  of  organization.  We  have  seen 
that  the  bill  brokers  are  primarily  middlemen;  though  they 
carry  some  of  the  acceptances  which  they  buy  until  maturity, 
thus  making  an  extended  investment  of  funds,  it  is  ordinarily 
their  intention  to  rediscount  all  of  their  purchases  whenever 
they  can  obtain  favorable  rates.  The  discoimt  house,  on  the 
other  hand,  is  nmch  less  a  middleman  and  more  a  financing 
institution  than  the  broker;  when  an  acceptance  has  been 
bought  by  the  discount  house,  it  is  usually  retained  until 
maturity.     Furthermoie,  the  two  differ  in  form  of  organiza- 


834  FOREIGN  EXCHANGE 

tion;  tlio  discoiint  house  is  much  like  a  commercial  bank, 
supjilying  a  rchilivcly  hirge  part  of  its  working  capital,  ac- 
coj)ting  deposits  upon  whicii  it  pays  interest,  and  engaging  to 
some  extent  in  investment  business  apart  from  its  purchases 
of  acceptances.  In  addition  to  the  capital  contributed  by 
the  shareholders  or  partners  in  the  discount  house,  or  received 
from  its  depositors,  working  funds  are  borrowed  on  short 
terms  against  deposits  of  collateral  security,  as  is  the  case 
with  the  brokers.  Almost  the  whole  of  this  capital  is  invested 
in  bills  of  exchange  of  various  maturities;  the  combined  assets 
of  the  discount  houses  of  London  are  large  enough  to  remove 
from  the  market  a  vast  amount  of  acceptances. 

78.  The  Bank  of  England.  This  great  institution  is  the  cor- 
nerstone of  the  London  market,  not  by  virtue  of  any  official 
power  which  it  wields,  but  because  of  the  nature  of  its  rela- 
tions with  the  other  money-lenders,  the  reliance  which  they 
place  in  it,  and  the  influence  which  it  may  exert  over  the  rates 
of  discount  which  rule  the  market.  It  is  a  private  institution, 
distinguished  by  the  fact  that  it  is  banker  to  the  British  Gov- 
ernment, is  custodian  of  the  cash  reserves  of  the  City  and  pro- 
vincial banks,  and  conducts  its  operations  with  a  view,  pri- 
marily, toward  the  public  interest.  The  Bank  is  made  up  of 
two  distinct  departments:  the  Issue  Department,  whose  sole 
function  is  the  issue  of  notes  against  prescribed  security  and 
the  redemption  of  these  notes  in  gold  on  demand;  and  the 
Banking  Department  which  engages  in  a  general  banking 
business.  It  is  with  the  latter  that  we  are  concerned  in  our 
study  of  foreign  exchange. 

The  banking  department  of  the  Bank  of  England  deals 
with  its  own  clientele  in  the  business  world,  as  does  any  other 
commercial  bank;  but  a  large  share  of  its  transactions  are 
carried  on  with  other  bankers  in  England  As  custodian  of 
the  cash  reserves  of  other  English  banks,  the  Bank  of  England 
carries  huge  current  deposits  which  must  be  so  invested  as  to 
be  kept  in  a  highly  liquid  form  against  any  emergency  which 
may  necessitate  an  increase  in  the  cash  resources  of  the  de- 
positing banks.  From  its  own  capital,  the  deposits  of  its 
business  clientele,  and  the  cash  reserves  of  other  English  banks, 


THE  EXCHANGE  MARKET— LONDON  335 

the  Bank  is  supplied  with  a  loan  fund  of  great  magnitude. 
Its  principal  function  as  a  credit  institution  is  that  of  redis- 
count, and  it  is  in  the  performance  of  this  function  that  the 
Bank  comes  in  contact  with  the  discount  market  and  exerts 
its  influence  over  the  dealings  in  bills  of  exchange  which  the 
market  carries  on.  The  Bank  buys  only  those  bills  of  ex- 
change which  have  been  accepted  by  English  drawees  and  are 
payable  in  England,  and  it  buys  none  of  these  in  the  open 
market;  that  is  to  say,  it  does  not  purchase  acceptances  gen- 
erally from  their  first  sellers,  as  do  the  brokers  and  discount 
houses,  but  takes  them  by  rediscount  from  those  of  its  own 
customers  who  have  bought  them  in  the  first  instance.  To 
become  regular  clients  of  the  Bank,  and  so  to  avail  themselves 
of  its  services  of  rediscount,  the  brokers  and  discount  houses  of 
London  carry  their  deposit  accounts  with  the  Bank  of  Eng- 
land. From  these  two  sources  are  drawn  the  acceptances 
in  which  the  Bank  invests;  thus  each  bill  in  the  possession  of 
the  Bank  bears  the  names  of  two  English  houses:  the  acceptor 
and  the  endorser  (bill  broker  or  discount  house)  who  first 
bought  the  bill  after  acceptance  and  has  resold  it  to  the  Bank. 
There  is  nothing  in  the  law  or  policy  of  the  Bank  of  England  to 
prevent  the  joint-stock  banks  of  London  from  rediscounting 
with  it  any  of  the  bills  which  they  hold,  but  custom  and  tra- 
dition have  decreed  that  these  institutions  retain  possession 
of  all  the  acceptances  they  buy,  it  being  considered  a  sign  of 
financial  instability  for  these  banks  to  resell  any  commercial 
paper  in  which  they  have  once  made  an  investment.  Hence, 
the  rediscounting  of  the  Bank  of  England  is  done  for  bill 
brokers  and  discount  houses,  and  not  for  the  great  incorpo- 
rated or  private  banks  of  the  city. 

The  essential  purpose  of  a  central  agency  of  rediscount,  such 
as  the  Bank  of  England,  is  to  provide  for  other  banking  in- 
stitutions a  method  of  relief  whenever  the  percentage  of  their 
cash  resources  to  demand  liabilities  becomes  dangerously 
low.  During  a  period  of  credit  expansion,  the  banks  of  any 
money  center  rapidly  increase  their  holdings  of  investment  in- 
struments, especially  the  commercial  paper  used  to  finance 
the  increasing  transactions  of  the  business  world,  at  the  same 


JV?0  FOREIGN  EXCHANGE 

time  multiplying'  the  deposit  liabilities  which  are  pnj'ablc  on 
deniand.  While  this  pnx'ess  is  under  way,  the  proportion  of 
cash  reserves  to  other  less  li(]uid  assets  of  the  banks  shrinks 
toward  the  point  where  danger  will  arise  of  an  insuflicicncy 
of  cash  to  meet  the  demands  of  the  banks'  creditors.  If,  at 
such  a  time,  no  method  is  available  whereby  the  banks  can 
liquidate  a  part  of  their  assets,  further  lending  must  stop, 
greatly  to  the  detriment  of  the  business  world  which  relies 
upon  a  continued  extension  of  credit  to  finance  operations 
already  begun,  until  the  gradual  maturing  of  the  commercial 
paper  held  by  the  banks  restores  the  balance  between  cash  and 
slow  assets.  This  stoppage  of  lending  may  be  sufficient,  in 
times  of  unusual  stress,  to  precipitate  a  panic  and  a  general 
breakdown  of  the  credit  structure  of  the  market.  The  relief  af- 
forded by  a  central  agency  for  rediscount  is  of  supreme  impor- 
tance at  such  times,  for  to  this  central  institution  the  banks 
may  sell  a  part  of  their  commercial  paper  and  thus  strengthen 
the  condition  of  their  cash  resources  without  adopting  the 
violent  expedient  of  calling  a  halt  to  their  lending  operations. 

In  the  London  market,  the  Bank  of  England  stands  as  an 
ever-ready  source  of  relief  in  times  of  credit  stringency;  its 
own  lending  operations  are  carefully  limited  in  normal  peri- 
ods that  it  may  hold  in  reserve  a  vast  power  to  rediscount  the 
assets  of  other  credit  institutions  whenever  the  emergency 
arises ;  and  during  its  long  history  it  has  never  failed  to  supply 
the  funds  required  for  the  relief  of  the  money  market.  Its  sup- 
port of  the  London  banks  as  a  rediscounting  agency  is  none  the 
less  effective  despite  the  fact,  mentioned  above,  that  these 
banks  are  forbidden  by  custom  directly  to  rediscount  any 
of  their  assets  with  the  Bank  of  England  even  in  times  when 
their  credit  is  extended  to  a  point  of  danger;  for,  as  we  shall 
see  presently,  these  banks  obtain  by  indirection  and  in  a  some- 
what roundabout  way  the  relief  which  business  custom  forbids 
them  to  seek  directly. 

To  illustrate  the  functioning  of  the  Bank  of  England  as  a 
rediscounting  agency,  let  us  assume  that  a  flood  of  accept- 
ances has  been  pouring  into  the  London  market  in  increasing 
volume  for  a  considerable  period  of  time.    A  part  of  these  ac- 


THE  EXCHANGE  MARKET  —  LONDON  S37 

ceptances  will  have  been  bought  by  the  banks  for  investment 
on  their  own  account;  another  part  will  have  been  absorbed  by 
the  bill  brokers  and  discount  houses  and  withdrawn  from  the 
market;  still  another,  and  a  large,  part  will  be  carried  by  these 
money-lenders  as  collateral  security  for  call  loans  with  which 
to  supply  the  funds  for  their  dealings  in  the  open  market. 
A  time  comes  when  the  loan  funds  of  London  are  extended  to 
their  full  capacity,  and  additional  discounting  of  acceptances 
becomes  difficult.  The  bill  brokers  and  discount  houses,  who 
rely  upon  the  readiness  of  the  banks  to  rediscount  accept- 
ances, find  that  these  banks  are  refusing  to  add  to  their 
holdings  of  commercial  paper;  unless  they  can  dispose  of  the 
bills  they  already  carry,  the  brokers  and  discount  houses  will 
have  reached  the  limit  of  their  power  to  discount  the  sterling 
acceptances  which  appear  on  the  London  market.  It  is  then 
that  they  turn  in  large  numbers  to  the  Bank  of  England,  re- 
discounting  there  the  bills  of  exchange  which  normally  would 
be  taken  off  their  hands  by  the  other  banks  of  London. 

At  the  same  time,  the  banks  of  the  city  are  very  probably 
laboring  under  the  necessity  of  liquidating  a  part  of  their 
assets  in  order  to  strengthen  the  loan  funds  which  have  been 
drained  away  during  the  period  of  credit  expansion.  Though 
they  do  not  rediscount  directly  with  the  Bank  of  England,  as 
do  the  brokers  and  discount  houses,  these  banks  adopt  ex- 
pedients which  virtually  accomplish  the  same  result.  Among 
their  assets  are  the  call  loans  of  the  brokers  and  discount 
houses,  supported  by  collateral  in  the  form  of  acceptances, 
and  of  all  their  assets  the  call  loans  are  the  most  available  for 
liquidation.  Accordingly,  the  banks  call  in  a  portion  of  these 
loans;  the  borrowers  cannot  repay  them  without  first  having 
disposed  of  the  collateral  upon  which  they  are  based,  and,  under 
the  conditions  which  obtain  at  the  time,  they  have  but  one 
means  of  disposing  of  this  collateral  —  by  rediscount  with  the 
Bank  of  England.  They  sell  the  acceptances  to  the  Bank, 
have  the  proceeds  placed  to  their  credit,  and  against  this 
credit  draw  checks  for  the  amount  of  the  loans  which  they  are 
under  obligation  to  repay  to  their  own  bankers;  the  checks  are 
deposited  by  their  bankers  in  the  Bank  of  England,  thus 


838  FOREIGN  EXCHANGE 

swollinp;  the  cash  reserves  which  the  hanks  carry  in  that  in- 
stitution and  accompHshing  the  end  which  the  banks  had  in 
view  when  caUing  in  their  loans:  namely,  to  turn  a  part  of 
their  paper  assets  into  cash  so  as  to  increase  the  proportion 
of  reserve  to  demand  liabilities.  By  this  roundal)Out  proc- 
ess, the  London  banks  compel  their  clients  to  do  what  they 
do  not  care  to  do  themselves;  that  is,  to  avail  themselves  of 
the  rediscount  function  of  the  Bank  of  England  when  it  be- 
comes necessary  to  liquidate  a  portion  of  their  assets. 

When  all  the  credit  institutions  of  London  are  turning  to 
the  Bank  of  England  in  this  manner,  the  Bank  is  obviously 
placed  in  a  strategic  position  from  which  to  make  its  influence 
felt  throughout  the  entire  money  market.  Clearly,  a  refusal 
of  the  Bank  to  rediscount  will  put  an  effectual  stop  to  the 
further  sale  of  acceptances  in  the  open  market;  furthermore, 
the  terms  which  the  Bank  chooses  to  exact  when  rediscount- 
ing  for  the  money-lenders  must  govern  them  in  setting  the 
rates  at  which  they  continue  their  dealings  in  bills  of  exchange. 
Now,  the  Bank  of  England  has  never  actually  refused  to  re- 
discount, though  there  is  no  law,  aside  from  long  standing 
custom  and  the  care  of  the  Bank  for  the  public  interest,  to 
prevent  such  refusal.  However,  the  Bank  is  free  to  establish 
its  rate  of  rediscount  at  any  point  which  it  thinks  advisable, 
thus  determining  the  purchasing  rates  of  other  dealers  in  the 
exchange  market  and,  accordingly,  the  ease  or  difficulty  with 
which  sterling  acceptances  may  be  sold.  At  such  a  time,  the 
published  rate  of  the  Bank  of  England  is  an  eflFective  governor 
of  all  the  discount  rates  of  the  open  market,  for  the  reason  that 
the  operators  in  the  market  are  forced  by  the  exigencies  of 
the  situation  to  obtain  the  funds  with  which  they  do  business 
by  paying  this  rate  to  the  Bank  of  England;  and,  of  course, 
they  cannot  carry  on  their  transactions  as  lenders  without  re- 
gard to  their  costs  as  borrowers.  This  opens  for  us  the  im- 
portant subject  of  the  influence  of  the  Bank  Rate  on  the  dis- 
count market  and  the  factors  which  make  this  rate  effective. 

79.  The  position  of  the  Bank  of  England  Rate  in  the  London 
market.  We  have  called  attention  above  to  the  fact  that  "the 
market  rate  of  discount"  is  not,  in  reality,  a  single  rate,  but  a 


THE  EXCHANGE  MARKET  — LONDON  S39 

group  of  rates  applying  to  bills  of  varying  maturity  and  term 
of  life.  When  the  expression  the  market  rate  is  employed,  refer- 
ence is  had  to  the  lowest  rate  of  the  system ;  that  is,  to  that  rate 
at  which  prime  bankers'  acceptances  of  sixty  or  ninety  days* 
usance  are  bought  in  the  open  market  of  London.  This  class 
of  acceptances  is  superior  to  all  others,  and,  consequently, 
the  terms  it  commands  are  more  favorable.  The  other  rates 
in  the  system  range  above  this  minimum  in  the  degree  to  which 
the  other  classes  of  bills  contrast  as  investment  instruments 
with  the  premier  quality  of  bankers'  acceptances.  The  spac- 
ings  between  the  different  rates  in  the  system,  however,  are 
always  fairly  fixed  and  constant;  the  whole  group  moves  in  a 
body  in  the  same  direction  whenever  the  conditions  of  the 
loan  market  are  such  as  to  cause  a  rise  or  fall  in  the  rate 
of  interest.  When  we  speak,  in  the  discussion  which  follows, 
of  the  relationship  existing  between  the  market  rate  of  dis- 
count and  the  Bank  Rate,  it  must  be  understood  that  the 
former  of  these  expressions  is  used  in  its  customary  meaning 
with  reference  to  the  price  offered  in  the  open  market  of 
London  for  prime  bankers'  acceptances. 

It  is  the  practice  of  the  directors  of  the  Bank  of  England 
to  make  public  every  Tuesday  the  rate  at  which  the  Bank  is 
prepared  to  discount  prime  bankers'  acceptances  for  the  fol- 
lowing week.  This  is  the  Bank  Rate,  formally  known  as 
"The  Official  Minimum  Discount  Rate  of  the  Bank  of  Eng- 
land," widely  quoted  by  financial  papers  the  world  over,  and 
accepted  by  all  financial  institutions  as  an  index  to  the  con- 
dition of  the  London  discount  market.  In  normal  times,  this 
rate  is  maintained  at  a  figure  which  is  fairly  regular  from 
day  to  day  and  week  to  week;  in  times  of  approaching  money 
stringency,  however,  it  is  advanced  to  higher  levels,  reflect- 
ing the  exhaustion  of  the  loan  funds  of  the  money  market; 
and  it  is  then  that  the  behavior  of  the  Bank  Rate  is  watched 
with  closest  scrutiny  by  the  financial  interests.  The  observa- 
tion of  men  whose  business  brings  them  in  contact  with 
the  money  market  of  London  has  shown  that  a  relationship 
exists  between  the  Bank  Rate  and  the  discount  rates  of  the 
market,  and  that  this  connection  is  especially  close  during 


840  FOREIGN  EXCHANGE 

those  periods  when  tlie  Bank  Rate  is  risiiifr.  ,1ust  what  the 
reUitionship  is,  however,  and  how  it  is  brought  about,  is  not 
often  clearly  understood.  As  a  matter  of  fact,  the  causal 
connection  between  the  two  rates  is  not  sinijilc  and  uniform, 
for  sometimes  the  Bank  Rale  is  tlie  effect,  sometimes  the  cause, 
of  the  market  rate  of  discount. 

The  degree  of  influence  exerted  by  the  Bank  Rate  over  the 
discount  rate  of  the  open  market  at  any  given  time  may  be 
said  to  depend  upon  whether  the  bulk  of  the  Bank's  business, 
at  that  time,  consists  of  discount  or  rediscount  operations. 
Like  every  commercial  bank,  the  Bank  of  England  carries  on 
the  customary  transaction  of  discount  and  deposit,  taking  up 
the  promissory  notes  of  its  clients  and  creating  deposit  or 
checking  accounts  in  favor  of  the  borrowers.  In  conducting 
this  business,  the  Bank  of  England  enters  into  competition 
with  the  other  London  banks,  establishing  direct  relations 
with  the  business  men  of  the  city  and  extending  credit  for  the 
use  of  these  men  in  their  ordinary  commercial  transactions. 
During  those  periods  when  the  loan  funds  of  the  London 
market  are  abundant,  the  business  of  the  Bank  is  principally 
of  this  sort;  the  other  banks  can  supply  from  their  own  re- 
sources the  funds  required  to  conduct  their  credit  transactions 
and  are  not  forced  to  resort  to  the  Bank  of  England  for  aid. 
Hence,  comparatively  little  rediscounting  is  done  by  the  Bank, 
and  its  published  Rate,  since  it  does  not  determine  the  cost 
at  which  the  brokers  and  discount  houses  obtain  their  funds, 
cannot  control  the  rate  of  discount  which  rules  the  market. 

During  these  periods  it  is  the  practice  of  the  governors  of 
the  Bank  to  base  the  Official  Rate  upon  the  rate  of  discount  for 
prime  bankers'  acceptances  which  the  uncontrolled  forces  of 
supply  and  demand  establish  in  the  market,  setting  the  Bank 
Rate  a  fraction  of  one  per  cent  higher  than  this  open  market 
rate.  But  this  Official  Rate  at  such  times  is  largely  a  for- 
mality; the  Bank  itself  does  not  use  it  for  the  conduct  of  its 
own  business,  but  in  its  negotiations  with  its  clients  offers 
better  terms  of  discount,  terms  which  conform  to  the  rate  at 
which  the  other  banks  of  the  city  are  doing  business.  The 
formal  character  of  the  Bank  Rate  under  these  conditions 


J 


THE  EXCHANGE  MARKET  — LONDON     341 

is  clearly  understood  by  the  other  money-lenders  of  the 
market;  indeed,  its  significance  at  such  times  inheres  in 
the  fact  that  it  is  a  formality,  for  it  stands  as  evidence  that 
"money  is  easy"  in  London,  that  there  is  a  large  reserve  of 
potential  credit  upon  which  business  men  can  rely  for  finan- 
cial assistance.  When  the  money-dealers  of  the  London 
market  are  able  to  absorb  the  supply  of  commercial  paper 
which  enters  the  market,  without  resort  to  the  rediscounting 
function  of  the  Bank  of  England,  the  statement  is  very 
properly  made  that  the  Bank  Rate  is  not  effective,  the  mean- 
ing being  that  it  exerts  no  influence  over  the  rates  at  which 
bills  are  discounted  by  brokers,  discount  houses,  and  other 
bankers.  Its  relation  to  the  market  rate  of  discount  is  then 
not  that  of  cause,  but  of  effect. 

But  the  situation  is  reversed  during  times  of  money  strin- 
gency when  the  Bank  begins  to  exercise  its  function  of  redis- 
count. We  have  seen  how,  in  such  times,  the  brokers  and  dis- 
count houses  are  driven  to  the  Bank  for  relief  from  a  part  of 
their  load  of  commercial  paper,  and  how  their  dependence 
upon  the  Bank  gives  it  power  to  influence  the  rates  at  which 
business  is  done  in  the  open  market.  It  has  long  been  the 
practice  of  the  Bank  of  England,  by  limiting  its  discount  op- 
erations during  periods  of  financial  quiet  to  a  fraction  of  the 
amount  made  possible  by  its  vast  resources,  to  save  its  lending 
power  for  use  in  such  emergencies.  When  rediscounting 
begins,  this  lending  power  is  called  into  play  to  absorb  a  part 
of  the  commercial  paper  of  the  brokers  and  discount  houses 
and  so,  indirectly,  to  strengthen  the  credit  of  the  other  banks 
of  the  city.  But  rediscounting  has  the  effect  of  reducing  the 
proportion  of  the  Bank's  reserve  to  its  liabilities,  and,  if  it 
continues  long  enough,  will  place  the  Bank  of  England  in  the 
same  condition  of  strained  credit  which  temporarily  charac- 
terizes the  other  banking  institutions  of  the  London  market. 
It  is  necessary  then  to  place  a  check  upon  the  lending  oper- 
ations of  the  entire  market,  not,  indeed,  by  means  of  a 
sudden  and  violent  cessation  of  loans,  such  as  must  take  place 
in  the  absence  of  a  central  agency  for  rediscount,  but  by 
discouraging  unnecessary  borrowing  and  making  loans  diffi- 


542  FOREIGN  EXCHANGE 

cult  to  get.  The  Bank  does  this  by  raising  the  OfBcial  Rate 
point  l>y  point  as  its  reserves  fall.  This  makes  it  increasingly 
expensive  for  the  brokers  and  discount  houses  to  rediscount 
with  the  13ank  of  England  and  causes  a  progressive  rise  in  the 
rates  at  which  they  conduct  their  transactions,  which,  in  turn, 
reduces  borrowing  and  checks  the  credit  expansion.  In  other 
words,  the  Bank  Rate  becomes  effective  as  a  governor  of  the 
market  rate  of  discount,  and  the  governors  of  the  Bank  are 
given  the  power  by  the  exigencies  of  the  situation  to  determine 
more  or  less  at  will  what  prices  bills  of  exchange  and  other 
commercial  paper  shall  command  in  the  open  market.  They 
use  this  power  to  restrict  credit  operations  in  London  and  so 
prevent  an  overexpansion  which  might  result  in  a  collapse 
of  the  credit  structure  of  the  market. 


CHAPTER  Xm 

THE  LONDON  MARKET  (continued) 

80.  The  Bank  Rate  and  the  flow  of  gold.  In  the  preceding 
chapter  we  have  examined  the  mechanism  of  the  London  dis- 
count market  and  described  the  dominant  position  of  the  Bank 
of  England  with  relation  to  it.  We  have  seen  how,  in  times  of 
money  stringency,  the  Bank  can  control  the  functioning  of 
the  discount  market  through  its  power  to  adjust  the  rediscount 
rate,  and  thus  dictate  the  terms  upon  which  the  brokers, 
discount  houses,  and  banks  of  the  city  buy  and  sell  accept- 
ances. It  is  our  present  purpose  to  take  a  broader  view  of 
this  power  of  the  Bank  of  England  and  inquire  to  what  extent 
and  in  what  manner  the  Bank  can  affect  the  relationship  of 
the  London  market  as  a  whole  to  the  rest  of  the  world. 

In  all  countries  using  the  gold  standard,  the  uninformed  ma- 
jority of  the  people  are  prone  to  exaggerate  the  importance  to 
the  nation  of  the  supply  of  precious  metal;  this  common  opin- 
ion is,  as  a  rule,  based  upon  incorrect  notions  concerning  the 
nature  of  money,  and  is  to  a  large  degree  fallacious.  Yet  there 
is  a  modicum  of  truth  in  the  error.  Nations  whose  monetary 
and  credit  structure  is  founded  on  a  gold  standard  cannot 
always  view  with  indifference  the  ebb  and  flow  of  the  gold 
stock;  there  are  times  when  a  continued  loss  of  gold  through 
exportation  may  threaten  a  depletion  of  the  gold  reserves  of 
the  banks  and  treasury  to  an  extent  which  affects  the  stability 
of  credit  and,  perhaps,  even  of  the  gold  standard  itself.  At 
such  times,  it  is  of  national  importance  to  check  or  limit  the 
outflow  of  gold,  or  to  spread  it  over  a  period  of  time  so  that 
readjustment  may  be  less  violent  and  severe.  Again,  when 
credit  operations  of  some  magnitude  are  in  prospect,  it  may  be 
important  to  induce  an  inflow  of  gold  which  would  not  other- 
wise occur,  or  to  hasten  and  concentrate  an  inflow  which  might 
otherwise  be  postponed  and  diffused.  Moreover,  in  the  past, 
these  gold  movements  have  been  of  peculiar  concern  to  Eng- 


344  FOREIGN  EXCHANGE 

land,  since  London,  the  greatest  free  gold  market  of  the  world, 
and  the  chief  center  of  international  credit,  has  been  most 
susceptible  to  demands  for  gold  from  other  nations  and  most 
concerned  to  maintain  a  sufficient  gold  reserve  to  ensure  be- 
yond all  question  the  validity  of  her  credit  structure.  In  this 
setting,  the  position  of  the  Bank  of  England  with  relation  to 
the  exchange  market  acquires  additional  significance;  the 
Bank  has  had  power,  while  maintaining  without  compromise 
its  obligation  to  surrender  gold  freely  to  all  bona  fide  creditors, 
to  exert  a  decisive  influence  over  the  magnitude  of  the  gold 
movements  to  and  from  England. 

To  make  clear  the  basis  of  this  power  and  to  explain  the 
method  by  which  the  Bank  has  brought  it  into  play  in  times 
past,  we  must  recall  the  condition  of  the  exchange  market 
which  causes  a  movement  of  gold  between  nations.  Speaking 
with  reference  to  London,  we  may  say  that  an  outflow  of 
gold  will  occur  when  the  sterling  sight  rate  in  other  markets 
has  fallen  to  the  specie  importing  point. '  ^^^^en  the  sterling 
sight  rate  in  New  York,  for  example,  has  settled  to  the  specie 
importing  point,  New  York  will  begin  to  draw  gold  from  Lon- 
don; for  at  this  quotation,  the  discount  on  bankers'  demand 
drafts  is  so  great  that  the  loss  to  the  bankers  from  converting 
their  London  credits  into  dollars  through  the  sale  of  drafts  is 
exactly  equal  to  the  expense  of  converting  these  credits  by  the 
alternative  method  of  importing  gold  from  London.  At  the 
specie  point,  therefore,  it  is  a  matter  of  indifference  to  the 
bankers  whether  they  avail  themselves  of  their  London  cred- 
its by  continuing  to  sell  sterling  checks,  or  by  instructing  their 
London  correspondents  to  ship  the  funds  on  deposit  at  the 
expense  of  the  depositing  bankers.  A  further  decline  of  the 
rate,  however  slight,  will  suflSce  to  turn  the  scale  in  favor  of 
gold  importation  as  an  alternative  to  the  sale  of  sterling  sight 
drafts,  and  the  result  will  be  an  outflow  of  gold  from  London. 

Conversely,  gold  moves  toward  London  when  the  sterling 
sight  rate  in  other  markets  has  risen  to  the  specie  exporting 
point.     Let  the  quotation  on  sterling  demand  drafts  rise  to 

1  We  refer  here  only  to  specie  movemeriLs;  commercial  shipments  of  raw 
gold  may  occm*  under  other  circumstances. 


THE  LONDON  MARKET  345 

this  point  in  New  York,  and  the  bankers  of  that  city  will  be- 
gin to  send  gold  to  London  to  place  themselves  in  position  to 
draw  sight  drafts  for  sale  on  the  favorable  market;  for  with  so 
high  a  premium,  they  will  gain  enough  from  the  sale  of  their 
drafts  to  offset  the  costs  of  shipping  the  gold  with  which  the 
drafts  are  redeemed.  Of  course,  not  all  bankers  will  be  re- 
quired to  ship  specie  in  order  to  take  advantage  of  the  favor- 
able market;  for  some  of  them  will  have  sufficient  credit  in 
London  to  meet  the  demands  of  their  customers.  But  others, 
not  in  this  position,  will  be  tempted  into  the  market  as  sellers 
of  sterling  exchange  by  reason  of  the  extremely  high  rates  and, 
lacking  London  credit,  they  will  be  compelled  to  place  gold  in 
the  hands  of  their  correspondents.  The  proximate  cause,  then, 
of  movements  of  gold  to  and  from  London  is  the  position  of 
the  sterling  sight  rate  in  other  markets;  hence,  any  power 
enjoyed  by  the  Bank  of  England  to  prevent  or  to  reduce  an 
outflow  of  gold  from  London  must  be  due  to  the  fact  that  the 
Bank  can  prevent  the  decline  of  the  sterling  sight  rate  to  the 
specie  importing  point  in  markets  outside  of  England;  while 
to  induce  or  increase  an  inflow  of  gold,  the  Bank  must  in  some 
way  raise  the  sterling  sight  rate  abroad  to  the  specie  export- 
ing point.  Our  problem,  therefore,  is  to  discover  wherein  lies 
this  power  of  the  Bank  over  the  selling  rates  of  foreign  bankers 
for  sterling  checks,  and  to  examine  the  practical  method  of  its 
exercise. 

At  the  outset,  we  must  lay  down  the  rule  that  the  quota- 
tion on  sterling  demand  drafts  in  New  York  and  elsewhere  is 
controlled  by  the  supply  and  demand  of  bankers'  checks 
drawn  on  London,  and  by  no  other  forces  whatsoever.  This 
rate  falls  to  the  specie  importing  point  only  when  the  supply 
of  bankers'  sterling  checks  is  so  large  that,  at  any  higher  rate 
of  exchange,  the  supply  will  exceed  the  demand.  Not  wishing 
to  be  left  with  unused  sterling  credits,  the  bankers  will  en- 
deavor to  encourage  the  sale  of  their  drafts  by  offering  them 
at  lower  rates  until  the  quotation  has  fallen  to  the  specie  im- 
porting point;  beyond  this  they  will  not  go,  preferring,  as  we 
have  seen,  to  withdraw  from  the  market  and  import  gold. 
The  decline  of  the  rate,  and  the  outflow  of  gold  from  London 


sm  IX)REIGN  EXCHANGE 

can  be  restrained,  effectually,  only  by  bringinfr  to  bear  on  the 
New  York  exehan<?c  market  an  influence  which  will  either 
increase  the  demand  for  bankers'  sterlin«:^  sight  drafts  or  re- 
duce the  supply  of  them,  or  exert  both  of  these  effects  at  the 
same  time.  On  the  other  hand,  when  the  demand  for  bankers' 
sterling  checks  is  in  excess  of  the  supply  at  lower  quotations, 
competition  among  the  buyers  will  produce  an  upward  trend 
of  the  rates  until  the  specie  exporting  point  is  reached,  beyond 
which  an  unlimited  supply  of  sterling  sight  drafts  will  appear 
on  the  market.'  If,  therefore,  when  the  sterling  sight  rate  in 
New  York  is  hovering  just  below  the  gold  exporting  point, 
it  is  considered  desiral)le  in  London  to  cause  the  rate  to  rise  so 
as  to  induce  an  inflow  of  gold,  this  can  be  done  only  by  in- 
creasing the  demand  for  bankers'  sterling  checks  in  New  York, 
or  decreasing  the  supply  of  them,  or  both.  This  power  to 
affect  the  conditions  of  demand  and  supply  for  sterling  ex- 
change in  markets  outside  of  England  has  been  wielded  by  the 
Bank  of  England  under  certain  favorable  conditions. 

Briefly  stated,  this  power  of  the  Bank  of  England  inheres  in 
its  control  over  the  discount  rates  in  the  open  market  of  Lon- 
don. As  we  have  seen  in  a  preceding  chapter,^  this  control  is 
not  absolute;  sometimes  the  Bank  Rate  is  the  effect  of  the  dis- 
count rate,  sometimes  the  cause.  It  is  only  when  conditions 
in  London  are  such  that  the  Bank  Rate  is  effective  in  ruling  the 
market,  that  the  Bank  of  England  can  carry  into  effect  any 
far-reaching  policy  looking  toward  restraining  an  outflow 
of  gold  from  London  or  inducing  an  inflow.  Hence,  in  the 
discussion  which  follows,  it  must  be  assumed  that  the  Bank  is 
actually  in  control  of  the  situation  during  the  period  in  ques- 
tion ;  that  is  to  say,  that  there  is  a  t  ightening  of  the  credit  supply 
in  the  market  and  the  money-lenders  are  forced  to  avail  them- 
selves of  the  rediscounting  function  of  the  Bank.  However, 
it  is  only  in  this  state  of  affairs  that  the  inflow  or  outflow  of 
gold  is  likely  to  be  a  matter  of  concern  to  the  money  market  of 
London;  hence,  we  can  say  that,  whenever  a  control  over  the 

^  If  further  explanation  of  the  specie  points  is  required,  the  reader  is  re- 
ferred to  the  discussion  on  pages  64  f. 
*  See  section  78. 


THE  LONDON  MARKET  S47 

gold  movement  is  to  a  great  degree  desirable,  the  Bank  will 
probably  be  in  position  to  exercise  such  control.  The  expe- 
dient by  means  of  which  the  governors  of  the  Bank  control 
the  gold  movement  is  merely  to  raise  the  Official  Bank  Rate 
and,  indirectly,  the  discount  rates  of  the  open  market.  They 
have  only  to  pursue  this  policy  consistently — that  is,  to 
raise  the  discount  rate  high  enough  —  and  the  effect  will 
be  to  lessen  the  supply  and  increase  the  demand  for  sterling 
sight  in  other  money  centers,  so  that  the  sterling  rates  will 
rise  above  the  specie  importing  point  and  the  loss  of  gold  from 
London  will  cease. 

The  discount  rate  in  the  London  market  is  brought  to 
bear  upon  the  sterling  long  bills  which  the  bankers  in  other 
centers  buy  and  forward  to  London  for  acceptance  and  dis- 
count. The  buying  price  for  these  long  bills  in  New  York 
and  other  markets  is  determined  by  the  rate  of  discount  at 
which  they  will  sell  after  acceptance.  ^  When  the  London  dis- 
count rate  rises  as  a  consequence  of  an  upward  movement  of  the 
Official  Rate  of  the  Bank  of  England,  the  quotation  on  ster- 
ling long  bills  in  New  York  will  fall;  that  is,  the  spread  be- 
tween the  sterling  long  rate  and  the  sterling  sight  rate  will 
broaden.  The  rising  discount  rate  in  London  will  not,  it  is 
true,  at  once  affect  the  sterling  sight  rate  in  other  markets 
— ■  that  rate  which  determines  the  movement  of  gold.  How- 
ever, it  will  exert  a  secondary  influence  over  this  rate,  an  influ- 
ence which  will  become  clear  when  we  recall  the  methods 
employed  by  the  bankers  when  handling  sterling  long  bills. 

These  long  bills  may  be  thrown  into  two  groups :  commercial 
bills  of  sixty  or  ninety  days'  sight  drawn  by  exporters  on 
British  firms  or  bankers;  and  bankers'  bills  of  the  same  tenor, 
consisting  largely  of  finance  bills,  drawn  in  connection  with  in- 
ternational lending  operations.  When  commercial  long  bills 
are  bought  by  bankers,  it  is  usually  with  the  intention  of  the 
buyers  to  discount  them  upon  arrival  in  London  and  carry  the 
proceeds  to  the  credit  of  their  foreign  balances.  This  they 
do  in  order  to  be  enabled  to  draw  a  corresponding  amount 
of  sterling  sight  drafts  for  sale  in  their  own  market.  But  the 
^  This  is  explained  on  pages  88  f. 


S48  FOREIGN  EXCHANGE 

hiiyint;  hnnkcrs  arc  not  under  obli<xalion  to  discount  the  ac- 
ceptances; they  may  choose  to  iinest  in  them  for  their  own 
account,  holding  them  until  maturity  for  the  gain  of  interest. 
What  their  decision  will  be  in  this  matter  will  obviously  dc' 
peiid  uj)()n  the  altraelivcncss  of  the  long  bills  as  investment  in- 
struments, and  this  will  depend,  in  turn,  ui)on  the  position  of 
the  discount  rate  in  London.     If  the  discount  rate  is  high,  the 
value  of  a  long  bill  at  acceptance  will  be  much  below  its  value 
at  maturity,  and  the  gain  of  the  buying  banker  will  be  cor- 
respondingly large,  if  he  decides  to  retain  the  bill  as  an  invest- 
ment.    How  high  the  London  discount  rate  must  rise  before 
bankers  in  New  York,  and  other  cities,  exercise  their  option  of 
holding  sterling  long  bills  for  investment  cannot  be  stated 
absolutely;  for  this  will  depend  in  part  upon  the  interest  rate 
in  New  York  which  determines  the  profit  to  be  derived  by  the 
bankers  from  the  alternative  use  of  their  funds.     But  this 
much  is  certain:  it  is  possible  for  the  discount  rate  in  London 
to  rise  so  high  that  bankers  will,  in  the  main,  refrain  from  dis- 
counting their  long  bills;  and  the  policy  of  the  Bank  of  England 
in  raising  the  rediscount  rate  will,  in  time,  eventuate  in  this 
result.     Now,  the  important  point  for  our  purpose  is  this: 
if  the  New  York  bankers  do  refrain  from  discounting  their 
sterling  long  bills,  they  must  also  forego  for  a  time  the  draw- 
ing of  sterling  sight  drafts  against  these  bills.    The  acceptance 
itself  adds  nothing  to  the  foreign  balance,  and,  if  held  off 
the  discount  market,  will  add  nothing  until  maturity;  in  the 
meantime,  the  supply  of  sterling  sight  drafts  in  New  York  will 
be  diminished  and  one  factor  making  for  a  lower  sterling  sight 
rate  will  be  removed. 

The  rising  discount  rate  will  also  exert  its  effect  upon  the 
bankers'  sterling  long  bill  drawn  in  connection  with  a  lending 
operation  between  the  bankers  of  the  two  cities.  The  New 
York  banker  draws  the  finance  bill  at  sixty  or  ninety  days' 
sight  upon  his  London  correspondent,  sells  the  bill  in  New 
York  and  employs  the  proceeds  on  short-term  loans  until 
required  to  redeem  the  correspondent  banker's  acceptance. 
The  buyer  of  the  sterling  long  bill  is  usually  another  New  York 
banker  who  uses  it  as  cover  for  his  sight  drafts  drawn  on  Lon- 


THE  LONDON  M.VRKET  349 

don.  The  supply  of  these  finance  bills,  therefore,  determines 
to  a  certain  extent  the  power  of  New  York  bankers  to  offer 
sterling  sight  drafts  on  the  market  in  New  York,  and  any 
influence  which  operates  to  discourage  the  drawing  of  finance 
bills  will  also  operate  to  reduce  the  supply  of  sterling  sight 
drafts.  Now,  no  finance  bills  are  drawn  on  London  unless 
the  discount  rate  in  that  city  is  appreciably  below  the  discount 
rate  in  the  drawing  market,'  since  the  profit  of  the  two  bank- 
ers concerned  in  the  transaction  is  conditioned  upon  this  dif- 
ference between  the  two  rates  of  discount.  Hence,  when  the 
Bank  of  England  adopts  a  rediscounting  policy  which  forces 
the  market  rate  of  London  to  rise,  this  policy  will  have  the 
effect  of  preventing  the  drawing  of  finance  bills  in  sterling 
by  bankers  in  foreign  markets;  this,  in  turn,  will  prevent  the 
buying  of  these  bills  as  cover  for  sterling  checks  by  other 
bankers  and  so  will  tend  to  diminish  one  of  the  forces  which 
depresses  the  sterling  sight  rate  toward  the  specie  importing 
point. 

In  one  other  way,  and  by  a  somewhat  more  roundabout 
process,  the  rising  discount  rate  of  the  London  market  tends 
to  decrease  the  supply  of  sterling  drafts  in  foreign  markets. 
In  normal  times,  the  excellence  of  the  London  market  as 
indicated  by  the  low  discount  rates  which  prevail  and  the  im- 
mensity of  the  loan  funds  which  the  market  commands,  at- 
tracts to  that  market  the  acceptances  of  bankers  payable  in 
foreign  cities.  These  acceptances  are  sent  to  London  for  dis- 
count in  preference  to  the  money  markets  of  their  respective 
places  of  domicile  because  the  relatively  low  discount  rates  of 
the  former  market  give  them  a  higher  sale  price  at  the  time  of 
acceptance.  When,  however,  the  owners  of  bankers'  accept- 
ances payable  in  francs  or  marks  elect  to  discotmt  them  in 
London  rather  than  in  Paris  or  Berlin,  they  acquire  sterling 
credits  of  which  they  must  avail  themselves  by  drawing  ster- 
ling drafts  for  sale  in  their  own  markets.  A  rising  discount 
rate  in  London  will  eventually  destroy  the  profitableness  of 
this  practice  of  discounting  there  the  acceptances  of  foreign 
bankers,  and  will  turn  into  other  money  centers  a  part  of  the 
»  This  matter  is  explained  at  length  on  pages  149  f. 


850  FOREIGN  EXCHANGE 

stream  of  bills  which  normally  flows  toAA-nrd  London.  This 
<liiniiuitic)n  in  the  numher  of  discount  items  forwarded  to 
I^ondon  will,  in  turn,  reduce  the  power  of  foreign  bankers  to 
draw  sterling  bills,  and,  consequently,  will  tend  to  restrain 
the  fall  of  the  sterling  sight  rate. 

We  have  discussed  three  effects  of  the  high  discount  rate 
in  the  London  market  which  cooperate  to  decrease  the  supply 
of  sterling  demand  drafts  in  other  cities.  We  shall  now  see 
that  in  two  different  ways  the  high  rate  tends  to  increase  the 
demand  for  sterling  sight  drafts,  and  thus  to  reenforce  the 
influence  of  the  decreased  supply  upon  the  sterling  rate  of 
exchange.  Considering  again  the  matter  of  sterling  finance 
bills,  we  recall  that  the  lending  operation  is  closed  out  when  the 
drawing  banker  buys  sterling  sight  drafts  and  forwards  them 
to  his  London  correspondent  to  cover  the  latter's  acceptance. 
Now,  many  of  these  loans  are  not  closed  out  at  the  term  of  the 
first  bill,  but  extended.  When  this  is  done,  the  drawing  banker, 
who  is  under  obligation  to  redeem  the  original  finance  bill, 
draws  a  second  long  bill  in  sterling  on  the  same  correspondent, 
sells  it  in  his  own  market  and  uses  the  proceeds  to  purchase  the 
required  cover.  Though  this  action  cancels  the  original  fi- 
nance bill,  it  does  not  terminate  the  loan;  for  the  London  cor- 
respondent no  sooner  discharges  his  obligation  as  acceptor 
of  the  original  bill  than  he  assumes  the  same  obligation  with 
respect  to  the  second,  and  the  New  York  banker  remains,  as 
before,  under  obligation  to  make  a  deferred  remittance  of 
cover  to  London.  When  the  loan  is  extended  in  this  fashion, 
the  redemption  of  the  original  finance  bill  cannot  be  said  to 
have  made  a  net  addition  to  the  demand  for  sterling  sight 
in  the  New  York  market,  since  the  buyer  of  the  second  fi- 
nance bill  will  have  acquired  power  to  draw  checks  on  Lon- 
don equal  in  amount  to  those  required  by  the  drawer  of  the 
bill.  On  the  other  hand,  when  the  loan  is  closed  out,  the 
drawer  of  the  finance  bill  must  buy  sterling  sight  drafts  with- 
out in  any  way  increasing  the  power  of  the  market  to  supply 
them;  in  other  words,  the  closing  out  of  the  loan  will  result  in 
a  net  addition  to  the  demand  for  sterling  sight. 

Now,  the  decision  as  to  which  course  to  pursue  when  a 


THE  LONDON  MARKET  351 

finance  hill  is  about  to  mature  in  London  —  whether  to  close 
out  the  loan  or  renew  it  —  will  turn  on  the  prospect  of  profit 
from  the  sale  of  the  second  finance  bill,  and  this  will  depend 
on  the  same  set  of  conditions  which  called  forth  the  original 
lending  operation.  If  the  discount  rate  in  London  is  still 
sufficiently  lower  than  in  New  York,  and  the  two  bankers  are 
satisfied  that  the  sterling  sight  rate  is  not  about  to  rise,  the 
loan  may  be  extended.  However,  if  the  London  discount  rate 
has  risen  in  the  meantime  so  far  as  to  remove  all  prospect  of 
continued  profit  from  the  loan,  the  loan  will  be  closed  out, 
causing  a  net  increase  in  the  demand  for  sterling  sight  in  the 
New  York  market. 

There  is  still  another  effect  to  be  considered.  When  the 
London  discount  rate  rises  sufficiently,  the  lending  operation 
just  discussed  will  be  reversed,  and  foreign  bankers  will  be 
induced  to  lay  out  funds  in  short-term  investments  on  the 
London  market.  In  the  past,  when  loan  funds  have  flowed 
from  New  York  toward  London,  the  method  employed  by 
the  bankers  has  not  been  the  exact  reverse  of  that  employed 
when  London  was  lending.  Finance  bills  have  not  been  drawn 
by  London  bankers  on  New  York  correspondents,  but  the  latter 
have  bought  sterling  demand  drafts  or  cable  transfers  and 
forwarded  them  to  London  for  encashment.  The  reason  for 
this  difference  lay  in  the  fact  that  bankers'  acceptances 
were  prohibited  by  the  laws  of  the  United  States  and  there 
existed  no  open  discount  market  in  New  York.  These  ob- 
stacles have  been  removed  since  the  passage  of  the  Federal 
Reserve  Act  in  1913,  but  the  new  system  has  not  as  yet  been 
tried  out  under  normal  conditions.^  Before  the  Great  War, 
therefore,  when  conditions  were  such  as  to  encourage  the  lend- 
ing of  funds  in  the  London  market  by  foreign  bankers,  an 
increase  in  the  demand  for  sterling  sight  drafts  has  been  the 
result.  This  factor,  tending  to  restrain  the  decline  of  the 
sterling  sight  rate,  has  not  been  so  potent  in  New  York  as 
have  the  others  which  we  have  considered,  since  the  London 
discount  rate  has  rarely  risen  above  that  of  New  York.     But 

^  The  conditions  operative  in  the  New  York  market  both  before  and  after 
the  passage  of  the  Federal  Reserve  Act  are  discussed  in  Chapter  XIV- 


352  FOREIGN  EXCHANGE 

it  has  hoon  possible  for  the  Bank  of  England  to  carry  its  poUry 
of  raisinj;  tlie  discount  rate  so  far  that  such  K)ans  would  I;c- 
comc  profitable,  and  this  result  has  sometimes  occurred  es- 
pecially with  regard  to  other  European  centers. 

Through  these  channels  the  Bank  of  England  has  been  able 
to  exert  an  influence  over  the  conditions  of  demand  and  supply 
for  sterling  exchange  in  foreign  markets.  It  is  customary  to 
summarize  the  effect  of  the  Bank's  policy  somewhat  as  follows : 
the  raising  of  the  discount  rate  in  London  discourages  the  out- 
flow of  loan  funds  from  that  city  and  encourages  the  inflow 
of  loan  funds  from  foreign  financial  centers.  This  statement 
is  misleading  in  that  it  calls  before  the  mind  the  picture  of 
foreign  bankers  arbitrarily  shipping  gold  to  London,  or  ceasing 
to  ship  gold  out  of  London,  in  order  to  make  loans  at  the  high 
rates  of  interest  which  prevailed  there;  whereas  the  policy  of 
the  Bank  of  England  has  had  the  particular  merit  of  working 
with  the  natural  forces  which  determine  the  rates  of  exchange 
in  markets  outside  of  England.  In  spite  of  this  objection, 
however,  the  statement  is  essentially  correct.  In  each  of  the 
transactions  we  have  discussed  there  has  been  involved  a  de- 
cision on  the  part  of  foreign  bankers  either  to  cease  to  borrow 
on  the  London  market  or  to  lend  on  that  market.  The  pur- 
chase of  sterling  long  bills  for  investment  instead  of  for  dis- 
count, the  discontinuance  of  the  practice  of  drawing  ster- 
ling finance  bills,  the  closing  out  of  loans  already  contracted, 
all  indicate  a  decision  by  foreign  bankers  to  withdraw  from 
the  London  discount  market  as  borrowers;  the  remittance  of 
demand  sterling  to  London  bankers  for  the  purpose  of  making 
loans  in  London  brings  foreign  bankers  into  the  discount 
market  of  that  city  as  lenders.  The  bankers  concerned  w^ith 
these  credit  operations  need  have  nothing  to  do  with  the 
transportation  of  gold  to  and  from  London;  but  their  action 
has  an  effect  upon  the  sterling  sight  rate  which  reacts  upon 
the  profits  of  all  bankers  engaged  in  shipping  gold,  and  con- 
trols their  operations.  It  is  not  to  be  assumed  that  the  Bank 
of  England  has  had  power  to  resist  the  operation  of  strong 
basic  forces — such  as  a  long-continued  unfavorable  balance 
of  trade  —  which  determine  the  larger  movements  of  the  rates 


THE  LONDON  MARKET  353 

of  exchange;  during  short -run  periods,  however,  its  policy  of 
adjusting  the  rediscount  rate  has  had  a  decisive  influence  over 
the  movements  of  gold. 

8i.  Other  expedients  for  controUing  the  movement  of 
gold.  Aside  from  absolute  surrender  of  specie  payment,  there 
is  no  method  of  restraining  an  outflow  of  gold  equal  in  effect- 
iveness to  the  method  considered  in  the  preceding  section. 
The  expedient  of  raising  the  discount  rate  in  the  open  mar- 
ket is  unique  in  that  it  works  upon  the  cause  of  the  gold  move- 
ment by  sustaining  the  rates  of  sterling  exchange  in  the  bank- 
ing centers  of  the  world,  and  it  does  this  by  cooperating  with 
the  basic  forces  of  demand  and  supply.  The  raising  of  the 
discount  rate  is  not,  however,  the  only  resource  of  the  Bank 
of  England  when  desirous  of  preventing  an  outflow  of  gold 
from  London.  Another  device  is  sometimes  employed,  aimed, 
not  to  restrain  the  sterling  sight  rate  from  falling  to  the  specie 
importing  point  in  other  markets,  but  to  lower  the  specie 
point,  itself,  so  that  a  further  fall  of  the  sight  rate  may  occur 
without  producing  an  outflow  of  gold  from  London. 

It  will  be  recalled  that  the  specie  importing  point  on  ster- 
ling exchange  in  New  York  is  determined  by  the  costs  of  trans- 
porting gold  from  London  to  New  York;  if  these  costs  amount 
to  two  cents  on  the  pound,  the  specie  importing  point  will  be 
4.8465;  if  they  amount  to  four  cents  on  the  pound,  the  specie 
point  will  be  4.8265.  Most  of  these  costs  consist  of  actual 
shipping  charges  —  cooperage,  freight,  cartage,  insurance, 
interest;  but  before  the  total  expense  incurred  by  importing 
gold  can  be  determined,  the  importer  in  New  York  must  turn 
the  gold  into  dollars  and  discover  what  amount  of  American 
money  he  has  in  hand  as  the  result  of  the  transaction.  Any 
influence  which  reduces  the  number  of  dollars  resulting  from 
the  transfer  of  a  sterling  credit  from  London  to  New  York  by 
gold  importation  must  be  considered  one  of  the  shipping 
costs  and  will  have  its  effect  in  determining  the  specie  point. 

Gold  is  obtained  for  exportation  from  London  by  present- 
ing bank  notes  to  the  I3ank  of  England  for  redemption  in  gold 
sovereigns;  the  Bank  is  not  ol)ligod  to  redeem  these  notes  in 
other  kinds  of  gold  —  bars,  or  foreign  gold  coins  —  though 


854  FOREIGN  EXCHANGE 

it  usually  has  a  supply  of  these  in  stock.  If  the  American 
importer  obtains  his  gold  in  the  form  of  sovereigns,  these 
will  he  paid  over  to  him  by  count:  one  gold  sovereign  for  each 
pai)er  pound;  but  he  must  turn  these  English  gold  pieces  into 
dollars  on  the  basis  of  iceight:  23.22  grains  of  fine  gold  for 
each  dollar.  Accordingly,  the  returns  from  his  transaction 
when  it  is  completed  will  be  much  affected  by  the  weight  of 
the  gold  pieces  obtained  from  the  Bank  of  England.  Now,  all 
coins  lose  weight  while  in  circulation,  and  the  mint  laws  of  all 
nations  take  this  inevitable  loss  into  acccount  by  establishing 
what  is  called  a  "limit  of  tolerance,"  which  states  how  light 
a  standard  coin  of  the  monetary  system  may  become  before  it 
loses  its  legal  tender  quality.  In  England,  a  gold  sovereign 
may  suffer  a  loss  of  weight  of  approximately  six  tenths  of 
one  per  cent  before  it  is  withdrawn  from  circulation;  sover- 
eigns, light  in  weight,  provided  they  fall  within  this  limit  of 
tolerance,  may  be  paid  out  by  the  Bank  of  England  in  dis- 
charge of  its  obligations  to  redeem  bank  notes  on  demand. 
When,  therefore,  the  Bank  wishes  to  restrain  an  outflow  of 
gold,  it  may  pay  out  these  light-weight  coins,  solely;  this  pol- 
icy will  increase  the  expense  of  the  foreign  banker  on  whose 
account  the  gold  is  withdrawn  by  giving  the  gold  a  lower 
value  when  turned  into  his  national  currency  on  the  basis  of 
weight.  It  will,  therefore,  lower  the  specie  importing  point  on 
sterling  exchange,  since  the  new  cost  must  be  taken  into 
account  in  determining  the  quotation  on  sterling  sight  drafts 
at  which  it  becomes  more  profitable  to  import  gold  than  to 
sell  checks  on  London. 

^^'hen,  on  the  other  hand,  the  importer  of  gold  asks  for 
bar  gold  or  American  eagles  at  the  Bank  of  England,  these 
will  be  sold  him  by  weight;  since  the  Bank  is  not  bound  to  re- 
deem its  notes  in  these  forms  of  money,  it  will  be  free  to  set 
its  own  price  upon  the  gold.  The  gold  bars  or  the  American 
coin  will  be  considered  a  commodity  whose  price  is  subject  to 
bargain  between  buyer  and  seller.  As  a  matter  of  practice, 
the  Bank  of  England  does  not  raise  its  selling  price  for  gold  in 
this  form  above  a  certain  rather  rigid  limit;  for  the  buyer  has 
always  the  alternative  of  demanding  gold  sovereigns  which, 


THE  LONDON  MARKET  855 

at  the  very  extreme,  cannot  be  more  than  six  tenths  of  one 
per  cent  light  in  weight,  and  he  will  adopt  this  alternative  if 
the  Bank's  selling  price  for  bullion  is  too  high.  But  some  va- 
riation in  the  Bank's  selling  price  there  is,  and  by  raising  this 
price  when  it  wishes  to  restrain  an  outflow  of  gold,  the  Bank 
can  add  to  the  costs  of  the  gold  shipment  and  lower  the  specie 
Importing  point  in  foreign  markets,  correspondingly.  These 
devices,  it  must  be  repeated,  do  nothing  to  prevent  the  de- 
cline of  the  sterling  sight  rate  and  so  do  not  affect  the  funda- 
mental cause  of  the  gold  movement;  but  when  the  forces 
which  are  depressing  the  rate  of  exchange  are  not  too  power- 
ful, the  expedient  of  removing  the  specie  importing  point  to  a 
lower  quotation  may  sufBce  to  forestall  an  outflow  of  gold 
from  London  until  a  change  in  the  conditions  of  demand  and 
supply  for  sterling  sight  drafts  abroad  puts  a  stop  to  the  decline 
of  the  rate. 

By  methods  correlative  to  these,  the  Bank  of  England  may 
lower  the  specie  exporting  'point  in  other  markets  on  sterling 
exchange,  and  induce  a  flow  of  gold  into  London  sooner  than 
it  might  otherwise  occur.  The  specie  exporting  point  is 
determined  by  the  costs  of  shipping  gold  to  London;  the  Bank 
can  reduce  these  costs  by  affecting  two  of  the  elements  of  which 
they  are  composed:  the  interest  charge,  and  the  value  of  the 
gold  in  English  money  upon  its  arrival  in  London.  Normally, 
interest  is  lost  while  gold  is  in  transit,  but  when  it  is  considered 
especially  desirable  to  encourage  the  importation  of  gold  into 
London,  the  Bank  of  England  adopts  the  policy  of  allowing 
the  importer  an  interest-free  loan  equal  to  the  value  of  the 
shipment  while  the  gold  is  in  the  hands  of  the  transportation 
company.  This  removes  one  of  the  costs  of  gold  importation. 
Again,  the  Bank  may  raise  slightly  its  buying  price  for  the 
gold,  thus  making  it  possible  for  the  importer  to  create  a  ster- 
ling credit  somewhat  greater  than  the  intrinsic  value  of  his 
shipment  by  depositing  the  gold  with  the  Bank  of  England. 
These  expedients,  by  making  it  less  expensive  to  foreign  bank- 
ers to  ship  gold  to  London,  have  the  effect  of  lowering  the 
specie  exporting  point  on  sterling  exchange  in  markets  out- 
side of  England,  and  thus  making  it  correspondingly  easier  for 


856  FOREIGN  EXCHANGE 

the  sterliiijj  si^ht  rate  to  rise  to  the  exporting  point.  Here, 
again,  the  Bank's  policy  will  liave  no  inflnencc  npon  tlie  rate 
of  exchange  itself;  hnt  when  the  rate  is  rising  as  an  elfcct  of 
other  forces,  this  policy  of  the  Bank  may  place  it  at  the  specie 
exporting  point  by  lowering  the  latter.  However,  no  great 
reliance  is  placed  in  these  more  arbitrary  methods  of  regu- 
lating the  flow  of  gold,  since  the  power  of  the  Bank  to  work 
through  its  control  over  the  rates  of  discount  in  the  open 
market  is  more  effective  and  far-reaching. 

Though  we  are  not  at  present  concerned  with  the  operation 
of  exchange  markets  other  than  London,  it  may  be  useful, 
by  way  of  throwing  into  clearer  light  the  peculiar  power  of 
the  Bank  of  England,  to  summarize  briefly  the  method  em- 
ployed in  other  financial  centers  to  control  the  ebb  and  flow 
of  the  gold  stock.  No  other  city  has  enjoyed  power  in  this 
regard  commensurate  with  that  of  London.  Relying  upon 
this  power  to  protect  herself  against  a  sudden  drain  of  gold, 
England  has  been  able  to  maintain  a  gold  standard,  w-ith  vast 
outstanding  liabilities  payable  on  demand,  upon  the  basis  of 
a  very  slender  gold  reserve.  Analysis  of  the  preceding  dis- 
cussion shows  that  the  secret  of  this  defensive  power  of  Eng- 
land has  consisted  in  two  essentials ;  in  the  first  place,  the  fact 
that  bankers  all  over  the  world  were  constantly  in  contact 
with  the  discount  market  of  London  because  of  their  immense 
dealings  in  sterling  long  bills;  and,  also,  the  fact  that  the  terms 
upon  which  these  bills  could  be  discounted  were,  in  times  of 
stress,  under  the  conscious  and  centralized  control  of  the  Bank 
of  England.  By  dictating  the  prices  for  this  stream  of  ster- 
ling long  bills  in  London,  the  Bank  could  alter  the  conditions 
of  demand  and  supply  for  sterling  sight  drafts  in  all  the  prin- 
cipal foreign  markets  and  so  affect  the  behavior  of  the  ster- 
ling sight  rates  all  over  the  world.  In  no  other  financial  center 
have  these  two  conditions  of  effective  control  over  the  move- 
ment of  gold  existed  simultaneously. 

New  York,  for  example,  has  lacked  both  of  these  essential 
conditions  until  very  recent  years,  for  there  has  been  neither 
a  central  control  over  the  interest  rates,  nor  a  stream  of  dollar 
long  bills  inflowing  from  foreign  markets.    In  Berlin  and  Paris, 


THE  LONDON  MARKET  357 

where  the  discount  rates  are  subject  to  qualified  control  by 
the  Reichsbank  and  the  Bank  of  France,  respectively,  the 
supply  of  acceptances  has  been  too  insignificant  to  affect  the 
conditions  in  the  exchange  markets  of  other  countries.  New 
York  has,  therefore,  had  no  protection  against  an  outflow  of 
gold  except  some  quite  arbitrary  interference  with  the  natural 
currents  between  the  financial  centers  of  the  world.  This  con- 
dition has  obtained  until  the  present,  though  there  is  reason  to 
believe  that,  with  a  restoration  of  normal  credit  conditions,  our 
new  banking  machinery  will  give  New  York  a  power  over  the 
gold  movements  somewhat  similar  to  that  enjoyed  by  London. 
Berlin  has  made  use  of  the  expedient  of  raising  the  discount 
rate  to  protect  her  gold  reserve,  but  has  been  forced  to  rely 
in  the  main  upon  supporting  policies  which  were  less  auto- 
matic and  more  arbitrary.  The  Reichsbank  had  adopted  the 
policy  of  carrying  among  its  assets  large  holdings  of  accept- 
ances payable  in  gold  standard  countries  (principally  Eng- 
land) which  it  was  at  liberty  to  return  for  sale  to  the  market 
on  which  they  were  drawn.  These  acceptances  have  been  used 
as  a  sort  of  protective  barrier  for  the  gold  reserves  of  the 
Reichsbank;  to  stop  an  outflow  of  gold,  arising  from  the  fact 
that  the  mark  sight  rate  had  fallen  to  specie  importing  point 
in  other  markets,  the  Reichsbank  would  return  these  accept- 
ances to  the  market  where  they  were  payable,  discount  them, 
and  use  the  proceeds  to  buy  up  mark  sight  exchange.  This 
action  would  retard  the  decline  of  the  mark  sight  rate.  When 
it  was  desired  arbitrarily  to  bring  gold  to  Berlin,  the  proceeds 
derived  from  discounting  the  acceptances  would  be  collected  in 
gold  from  the  central  bank  of  the  market  and  shipped  in  that 
form  to  Germany.  So  long  as  the  gold  standard  was  main- 
tained in  the  country  where  the  acceptances  were  payable, 
their  possession  by  the  Reichsbank  constituted  a  claim  for 
an  equivalent  amount  of  gold,  which  claim  could  be  pressed 
at  any  time.  These  devices,  though  effective  over  short-run 
periods,  have  had  at  best  but  a  temporary  influence;  once  em- 
ployed, their  effectiveness  was  at  an  end,  and  they  could  exert 
no  continuing  influence  as  does  the  manipulation  of  the  dis- 
count rate  by  the  Bank  of  England. 


358  FOREIGN  EXCILVNGE 

France  is  not  committed  to  an  unqualified  gold  standard  as 
is  Cioriuany  aiui  England.  In  her  monetary  system — the 
"limping  standard"  similar  to  that  of  the  United  States  — 
both  gold  and  silver  coins  possess  legal  tender  power;  nor  are 
the  silver  five-franc  pieces  convertible  into  gold,  for  in  France 
a  condition  obtains  very  like  that  of  the  United  States  where 
the  silver  dollar  is  redeemable  in  gold  only  at  the  option  of  the 
banks.  Accordingly,  the  Bank  of  France  has  had  a  very 
effective  method  of  protecting  its  gold  reserves  in  times  of 
stress;  it  merely  exercised  its  legal  right  to  redeem  notes  in 
silver  when  gold  was  being  withdrawn  in  large  quantities  for 
export.  Thus  estopped  from  obtaining  gold  from  the  central 
bank,  the  exdiange  dealers  have  been  compelled  to  buy  it  as 
a  commodity  in  the  form  of  bars  or  foreign  coins;  and,  since 
the  Bank  of  France  has  been  the  principal  holder  of  gold  in 
this  form,  they  have  been  compelled  to  accede  to  the  Bank's 
terms  of  sale.  This  has  given  into  the  hands  of  the  Bank  the 
power  to  increase  the  costs  of  importing  gold  from  Paris  into 
other  markets,  and  thus  to  lower  the  specie  point  on  franc 
exchange.  Paris  has  never  acquired  the  reputation  of  a  free 
gold  market;  holders  of  franc  bills  have  not  been  assured  of 
their  ability  at  all  times  to  convert  their  bills  into  their  nom- 
inal gold  equivalent;  and,  therefore,  the  specie  point  on  franc 
exchange  has  been  open  to  fluctuations  in  harmony  with  the 
policy  of  the  Bank  of  France.  Relying  upon  this  power  to 
control  gold  movements,  the  Bank  of  France  has  rarely  had 
recourse  to  the  expedient  of  raising  the  discount  rate;  but  the 
policy  has  done  something  to  prejudice  the  standing  of  Paris 
as  a  center  of  international  finance,  and  to  prevent  her  from 
acquiring  the  unquestioned  credit  standing  enjoyed  by  Lon- 
don. 

82.  The  bases  of  London's  supremacy.  The  proof  of  the 
dominance  of  London  among  the  exchange  markets  of  the 
world  has  been  the  use  of  the  sterling  long  bill  as  the  standard 
financing  instrument  in  non-British  trade.  Bills  drawn  in 
the  other  European  currencies  and  in  dollars  have  been,  in 
the  main,  restricted  to  the  trade  to  which  the  countries  using 
these  moneys  were  party;  sterling  bills,  alone,  have  been 


I 


THE  LONDON  MARKET  359 

largely  employed  in  the  trade  of  the  world  in  general.  Long 
bills  drawn  on  London  bankers  have  streamed  into  the  dis- 
count market  of  London  from  all  the  trading  centers  of  the 
world,  there  to  be  absorbed  at  low  rates  of  discount  by  the 
brokers  and  money-lenders  of  the  open  market;  their  maturity 
in  continuous  sequence  has  called  for  the  remittance  to  Lon- 
don of  a  corresponding  volume  of  sterling  sight  drafts  drawn 
by  foreign  bankers  upon  their  London  balances  for  the  benefit 
of  business  men  everywhere  who  were  under  obligation  to 
make  payment  for  goods  imported,  or  services  enjoyed,  in 
international  commerce.  Thus,  in  the  decades  preceding  the 
Great  War,  London  held  without  question  the  position  of  the 
greatest  clearing  house  for  the  world's  commercial  credits. 
Since  the  war,  however,  there  has  been  a  tendency  among 
American  students  and  writers  to  call  into  question  this  posi- 
tion of  London,  and  to  express  the  belief  that  New  York  will 
soon  supplant  her  as  a  center  of  foreign  exchange.  To  throw 
some  light  upon  this  problem  and  to  prepare  the  ground  for 
our  discussion  of  the  New  York  market  in  the  chapter  which 
follows,  we  shall  undertake  now  to  summarize  the  bases  upon 
which  the  position  of  London  has  rested  in  the  past. 

Any  inquiry  into  the  causes  of  London's  supremacy  must 
begin  with  a  consideration  of  the  question  why  business  men 
in  the  world's  trading  centers  have  preferred  to  employ  ster- 
ling long  bills  rather  than  bills  drawn  in  other  moneys.  At 
the  outset  of  this  inquiry,  it  must  be  understood  that  the 
nature  of  the  bill  of  exchange  which  arises  from  a  given  trans- 
action in  foreign  trade  is  but  one  of  the  many  details  covered 
by  the  terms  of  sale;  and  that  the  decision  of  the  two  parties 
is  made  upon  the  basis  of  superior  convenience  and  economy. 
If  the  sterling  long  bill  has  been  more  widely  employed  than 
have  bills  of  other  kinds,  it  is  because  this  type  of  exchange 
has  possessed  such  superiorities  as  a  financing  instrument  that 
its  use  would  increase  the  profits,  or  reduce  the  costs,  of  the 
traders.  Examining  the  matter  from  the  point  of  view  of  the 
exporter,  the  reason  for  this  preference  for  sterling  is  not  far 
to  seek:  this  type  of  exchange  could  be  sold  to  bankers  with  a 
minimum  of  difficulty  and  at  rates  which  were  both  relatively 


:u;o  FOREIGN  EXCHANGE 

low  and  stable  as  compared  with  rates  for  other  kinds  of  hills. 
Possessed  of  a  sterlinj^  London  bill  dr.awn  upon  a  London 
banker,  the  exporter's  financing  costs  and  risks  of  exchange 
were  reduced  to  a  inininuun,  and  this  fact  reacted,  not  only 
to  the  larger  profit  of  the  exporter,  but  also  to  the  benefit  of 
the  importer  in  the  form  of  lower  prices  or  better  credit  terms. 
Thus,  self-interest,  the  final  authority  in  matters  of  business, 
has  encouraged  the  use  of  sterling  exchange. 

However,  it  becomes  apparent  upon  reflection  that  these 
characteristics  of  the  sterling  long  bill  which  have  commended 
it  to  the  business  men  —  namely,  marketabihty  and  favorable 
and  stable  rates  of  exchange  —  are  qualities  bestowed  upon 
sterling  exchange  by  the  bankers  who  create  a  market  for  the 
cretlit  instruments  of  the  exporter.  The  ease  with  which 
sterling  long  bills  could  be  sold  in  all  quarters  of  the  world  has 
been,  of  course,  but  a  reflection  of  the  willingness  of  bankers 
to  acquire  credits  in  London;  the  favorable  buying  prices, 
and  the  stability  of  the  sterling  rates,  have  been  due  to  the 
broad,  competitive  market  created  by  the  buying  bankers, 
and  to  the  fact  that  minimum  rates  of  discount  were  used  to 
compute  the  buying  rates  for  sterling  exchange.  When, 
therefore,  we  say  that  the  preference  of  business  men  for  ster- 
ling exchange  has  been  due  to  the  superior  economy  of  these 
bills,  we  but  restate  our  problem  in  another  form.  It  re- 
mains to  inquire  why  the  bankers  who  deal  in  foreign  ex- 
change have  accorded  especially  favorable  treatment  to  bills 
drawn  on  London. 

The  willingness  of  bankers  to  buy  bills  drawn  on  any  finan- 
cial center  is  governed  by  the  demand  in  their  markets  for 
the  checks  which  they  draw  against  the  credit  created  by 
these  bills.  Long  bills  payable  in  out-of-the-way  places  will 
not  be  bought  by  the  bankers  at  all,  but  will  be  handled  for 
collection  only;  of  all  kinds  of  exchange,  the  bankers  will  show 
the  least  hesitancy  in  buying  those  drawn  upon  a  city  where  it 
is  profitable  to  maintain  a  credit  —  profitable,  because  the 
bankers'  clients  are  continually  in  need  of  sight  drafts  payable 
out  of  that  credit.  As  for  the  discount  rates  employed  by  the 
bankers  in  determining  their  buying  prices  for  long  bills. 


THE  LONDON  MARKET  361 

these,  as  we  know,  are  taken  from  the  published  rates  of  the 
market  in  which  the  acceptances  will  be  sold;  that  is  to  say, 
the  buying  prices  for  sterling  long  bills  are  determined  by  the 
discount  rates  of  London,  those  of  dollar  long  bills  by  the 
discount  rates  of  New  York,  etc.  Here,  then,  are  two  basic 
factors  which  have  promoted  the  use  of  sterling  long  bills  in 
foreign  trade :  (a)  the  great  demand  in  all  quarters  of  the  world 
for  sterling  sight  drafts;  (6)  the  low  discount  rates  and  the 
tremendous  absorbing  power  of  the  London  market.  We 
shall  now  examine  these  factors  briefly. 

The  widespread  demand  for  bankers'  sterling  sight  drafts 
has  been  of  complex  origin.  Obviously,  we  have  here  an 
interaction  of  cause  and  efiFect,  for  the  very  fact  that  sterling 
long  bills  have  been  widely  used  as  financing  instruments  has, 
of  itself,  resulted  in  a  broad  and  widely  diffused  demand  for 
sterling  sight  drafts.  Importers  who  establish  London  credits 
in  favor  of  exporters  are  obliged  to  make  a  deferred  remittance 
of  sight  drafts  to  meet  the  exporter's  bill  at  maturity.  De- 
mand for  sterling  sight  drafts  arising  from  this  source,  how- 
ever, will  not  of  necessity  appear  in  the  same  market  where 
exporters  are  offering  sterling  long  bills  for  sale  in  large  num- 
bers. For  example,  if  importations  of  raw  silk  from  Japan 
to  America  are  financed  by  sterling  letters  of  credit,  a  supply 
of  sterling  long  bills  will  appear  in  Japan  and  a  demand  for 
sterling  sight  in  America  at  a  later  date.  This  particular 
demand  for  sterling  sight  drafts  will  not  avail  to  employ  the 
London  credits  of  Japanese  bankers  who  buy  the  sterling  long 
bills.  To  effect  a  substantial  equilibrium  of  demand  and 
supply  for  sterling  exchange  in  Japan  through  the  use  of  let- 
ters of  credit,  Japanese  importers  must  employ  these  letters 
to  the  same  extent,  approximately,  as  do  Japanese  exporters. 
It  is  conceivable  that,  in  some  markets,  the  sterling  credit  is 
used  by  these  two  sets  of  business  men  in  roughly  equivalent 
amounts,  so  that  the  use  of  sterling  exchange  as  a  financing 
agency  alone  clears  the  accounts  of  the  bankers;  but  this  can- 
not be  true  generally.  The  widespread  and  stable  demand  for 
sterling  sight  drafts  which  keeps  the  London  balances  of  for- 
eign bankers  employed  arises  from  other  sources  and  is  cre- 
ated by  other  economic  factors. 


862  FOREIGN  EXCIL\NGE 

Encfland  was  the  first  among  modern  nations  to  develop  a 
foreign  commerce  with  widely  scattered  world  markets.  For 
hundreds  of  years,  her  goods  have  been  sold  to  foreign 
peoples.  To  her  own  export  trade  is  to  be  attributed  a  share 
in  the  creation  of  that  vast  amount  of  current  indebtedness 
of  foreign  countries  which  has  resulted  in  a  seasonal  de- 
mand for  sterling  sight  drafts.  Again,  England  early  be- 
came a  creditor  nation  and  is  to-day  the  greatest  of  creditor 
nations.  Her  investments  in  Asia,  Africa,  Australasia,  the 
Far  East,  and  North  and  South  America  had,  according  to 
the  best  estimates,  reached  in  1914  the  tremendous  total  of 
twenty-one  billions  of  dollars  and  were  increasing  at  the  rate 
of  a  billion  a  year.  These  investments  have  brought  con- 
tinuous accruals  of  interest  and  principal  in  vast  amounts  and 
at  widely  separated  points,  which,  in  turn,  have  created  a 
continuous  and  diffused  demand  for  sterling  exchange.  Eng- 
land's merchant  marine  carries  the  freight  of  other  nations  to 
an  extent  not  equaled  by  any  competitor,  and  the  consequent 
payment  of  freight  charges  to  English  shipowners  has  con- 
tributed to  the  demand  for  sterling  exchange  in  foreign  mar- 
kets. These  economic  foundations  have  been  built  up  by 
long  years  of  endeavor  and,  though  shaken  by  the  terrible 
strain  of  the  Great  War,  they  remain  to-day  virtually  intact. 
The  demand  for  bankers'  bills  on  London  rests  upon  these 
firm  foundations;  variable  and  independent  as  these  economic 
forces  are,  they  serve  to  compensate  one  another,  stabilizing 
the  bankers'  market  for  sterling  exchange  and  protecting  it 
against  the  discontinuous  and  erratic  movements  which 
would  otherwise  result  from  the  ebb  and  flow  of  international 
commerce.  As  a  consequence,  the  balance  maintained  in 
London  by  foreign  bankers  has  shown  a  high  rate  of  turnover; 
to  repair  this  balance,  the  bankers  have  been  ready  to  buy 
sterling  long  bills  at  all  times. 

Let  us  now  inquire  into  the  causes  of  the  low  discount  rates 
which  have  been  employed  by  buying  bankers  when  com- 
puting their  prices  for  sterling  long  bills.  Other  things  equal, 
the  exporter  will  choose  as  a  financing  instrument  that  kind 
of  exchange  which  will  sell  for  the  highest  price  in  his  own 


THE  LONDON  MARKET  36S 

money;  or,  to  state  it  in  other  terms,  that  kind  of  exchange 
which  will  command  the  lowest  rate  of  discount  when  sold 
after  acceptance.  Assume,  for  example,  that  in  some  foreign 
market,  such  as  Hongkong,  the  dollar  and  the  sterling 
sight  rates  are  both  at  par,  but  that  in  London  the  dis- 
count rate  for  prime  bankers'  acceptances  is  three  per  cent 
while  in  New  York  the  rate  for  the  same  class  of  bills  is  five 
per  cent.  Under  these  conditions,  the  exporter  in  Hongkong, 
even  if  he  can  sell  both  kinds  of  exchange  with  equal  ease,  will 
prefer  to  finance  his  sale  in  sterling,  since  by  so  doing  he  can 
save  two  per  cent  of  the  face  of  the  bill  in  financing  costs. 
This  preference  for  sterling  will  lead  him  to  quote  better  terms 
to  those  buyers  who  agree  to  provide  a  sterling  credit  than  to 
those  who  instruct  him  to  draw  in  dollars.  If  this  buyer  is  an 
American  importer,  self-interest  will  induce  him  to  make  pay- 
ment in  sterling  rather  than  in  dollars,  and,  contrary  to  com- 
mon opinion,  this  patronage  of  London  banks  in  preference  to 
those  of  his  own  country  will  react  to  the  benefit  of  himself 
and  his  market,  in  the  same  manner  that  any  saving  of  costs 
results  in  gain.  The  establishment  of  American  branch  banks 
in  Hongkong  will  not  suffice  to  overcome  this  preference  for 
sterling  exchange  so  long  as  the  discount  rate  of  London  re- 
mains appreciably  below  that  of  New  York.  In  the  past, 
London  has  underbid  other  financial  centers  with  respect  to 
the  rates  of  discount;  v/hile  this  remains  true,  there  is  little 
likelihood  that  sterling  will  lose  its  position  of  dominance  in 
the  exchange  markets  of  the  world. 

The  low  discount  rates  of  London  have  been  due  partly  to 
the  vast  supply  of  loan  funds  which  seek  investment  there; 
partly,  also,  to  the  mechanism  of  the  market  which  has  turned 
these  funds  into  the  market  for  bills  of  exchange  rather  than 
in  the  direction  of  other  kinds  of  short-term  investment. 
The  same  forces  which  early  placed  England  in  the  lead  as  a 
lending  nation  made  of  the  London  money  market  a  vast 
reservoir  of  liquid  capital  seeking  employment  for  short  terms. 
The  industrial  development  of  England  began  earlier  than 
that  of  other  nations,  and  this  early  exploitation  of  invest- 
ment opportunities  within  the  country  at  once  accelerated  the 


864  FOREIGN  EXCHANGE 

pnco  of  capital  aocunmlation  and  forced  investors  to  look 
abroad  for  profitable  enii)loynieuL  for  tiieir  savinj^s.  As  the 
supply  of  capital  increased,  it  flowed  in  increasing  volume  to 
the  financial  center  of  the  country,  there  to  seek  investment 
at  rates  of  interest  which,  under  the  stress  of  competition 
among  the  lenders,  fell  to  very  low  points.  At  the  same  time, 
the  mechanism  of  the  mone}^  market  developed  along  lines 
which  encouraged  the  use  of  this  vast  supplj'  of  loan  funds  in 
the  purchase  of  bankers'  acceptances,  and  thus  brought  the 
low  discount  rates  to  bear  upon  sterling  long  bills  bought  and 
sold  in  foreign  markets.  Bankers  and  acceptance  houses 
adopted  early  the  practice  of  making  acceptances  for  the  ac- 
count of  their  clients,  thus  resolving  the  trade  bill  into  a  credit 
instrument  of  the  very  best  quality,  affording  the  security 
demanded  by  the  investor  of  liquid  capital.  Bill  brokers  and 
discount  houses  multiplied,  widening  the  market  for  these 
acceptances  and  narrowing  the  range  of  fluctuation  in  the 
rates  of  discount.  The  Bank  of  England,  first  and  greatest 
of  modern  central  banks,  afforded  the  rediscount  opportunity 
necessary  to  stabilize  the  market,  to  prevent  sudden  tighten- 
ing of  credit,  and  to  increase  the  confidence  of  the  smaller 
money-lenders.  Of  utmost  importance  in  its  effect  upon  the 
market  for  bills  of  exchange  was  the  practice  of  the  great 
commercial  banks  of  the  city  in  choosing  to  carry  their  liquid 
reserves  in  the  form  of  discounted  acceptances.  In  New 
York,  these  reserves  are  invested,  to  a  large  extent,  in  call 
loans  secured  by  collateral  of  stocks  and  bonds,  and  thus  are 
absorbed  in  the  speculative  activities  of  the  Stock  Exchange. 
But  in  London,  the  practice  of  fortnightly  settlement  by  the 
Stock  Exchange  prevented  this  employment  of  the  liquid 
reserves  of  the  banks;  bankers'  acceptances  afforded  the  safest 
and  most  readily  convertible  means  of  equalizing  the  cash 
position  of  the  commercial  banks,  and,  accordingly,  these 
large  reservoirs  of  loan  funds  have  found  their  outlet  in  the 
open  market  for  bills  of  exchange.  The  final  result  of  these 
developments  has  been  to  reduce  the  financing  costs  of  for- 
eign merchants  who  have  employed  the  sterling  long  bill  as  a 
financing  agency. 


THE  LONDON  MARKET  S65 

This  summary  of  the  forces  which  have  perfected  the  dis- 
count market  of  London  would  be  incomplete  without  some 
reference  to  the  gold  standard  policy  of  England.  Gold, 
more  than  any  other  metal,  possesses  international  purchasing 
power;  bankers  are  encouraged  to  maintain  balances  in  for- 
eign money  centers  when  they  have  confidence  in  their  ability 
to  convert  these  credits  into  gold  at  all  times.  London,  be- 
fore the  Great  War,  was  the  only  city  in  the  world  whose 
record  of  discharging  her  obligations  in  gold  without  question 
was  of  long  enough  standing  to  have  inspired  in  foreign  bank- 
ers an  implicit  confidence  in  the  validity  of  her  credit.  This 
reputation  of  London  as  the  only  "free"  gold  market  has  had 
its  part  to  play  in  accounting  for  the  supremacy  of  sterling 
exchange.  ^ 

1  The  statements  made  in  this  chapter  concerning  the  movement  of  gold 
between  the  nations  refer,  of  course,  to  normal  conditions.  At  the  time  of 
writing  (1921)  the  gold  standard  has  broken  down  almost  universally.  We 
cannot  base  our  discussion  of  the  laws  which  control  the  exchange  markets 
upon  abnormal  and  temporary  conditions,  however. 


CHAPTER  XIV 

THE  NEW  YORK  MARKET 

83.  Fonner  position  of  the  New  York  market.  The  rise  of 
New  York  to  prominence  among  the  exchange  markets  of  the 
world  has  been  a  matter  of  very  recent  development,  dating 
from  the  outbreak  of  the  Great  War.  Prior  to  1914,  New 
Y'ork's  position  was  in  no  w^se  comparable  to  the  position  of 
London.  The  financing  of  our  trade  fell  largely  into  the 
hands  of  London  banks;  letters  of  credit,  when  issued  by  our 
bankers,  were  usually  sterling  letters;  sterling  long  bills  and 
demand  drafts  were  employed  in  large  volume  by  our  traders 
to  perform  the  collection  and  financing  services,  and  to  make 
the  remittances,  required  in  our  commerce  with  foreign  mar- 
kets. Since  1914,  however,  due  partly  to  changes  in  our  bank- 
ing laws  and  to  internal  developments  which  were  the  conse- 
quence of  these  changes,  and  partly  to  the  effects  of  the  war 
which  broke  up  the  settled  channels  of  commerce  and  im- 
paired the  operation  of  the  London  exchange  market,  the 
progress  of  New  York  has  been  very  rapid.  It  will  help  us 
toward  an  understanding  of  the  present  mechanism  of  the 
New  York  market  to  examine  briefly  the  conditions  which 
obtained  prior  to  these  recent  developments. 

The  inadequacy  of  the  mechanism  of  the  New  York  ex- 
change market  to  meet  the  needs  of  a  financial  center  in  inter- 
national commerce  will  become  apparent  when  we  review  the 
handicaps  under  which  that  market  labored  before  the  pas- 
sage of  the  Federal  Reserve  Act  in  1913.  In  the  first  place, 
bankers'  acceptances  were  virtually  unknown;  the  practice  ot 
making  acceptances  was  prohibited  to  bankers  of  the  national 
banking  system  by  federal  law,  and  a  similar  prohibition  in 
the  state  laws  prohibited  the  practice  to  other  bankers.  This 
handicap  was  of  itself  sufficient  to  prevent  the  use  of  dollar 
letters  of  credit  both  by  our  own  merchants  and  by  those  of 
other  countries,  since  the  letter  of  credit  is  an  instrument 


THE  NEW  YORK  MARKET  367 

devised  for  the  particular  purpose  of  utilizing  the  banker's 
acceptance.  When  foreign  exporters  drew  long  bills  in  dol- 
lars, these  bills  were  drawn  almost  entirely  upon  business 
men,  and,  hence,  became  trade  acceptances  difficult  to  market 
with  the  drawer's  bank  and  subject  to  widely  fluctuating 
rates  of  exchange. 

Closely  related  to  the  absence  of  bankers'  acceptances  was 
a  second  great  weakness:  the  lack  of  an  open  market  for  bills 
of  exchange.  The  banker's  acceptance  is  an  instrument  well 
adapted  to  the  needs  of  the  discount  market;  it  is  always 
clean  after  acceptance,  thus  being  readily  transferred  by  en- 
dorsement and  having  a  fixed  maturity;  its  credit  standing  is 
of  the  highest;  it  can  be  resold  without  difficulty,  and,  hence, 
is  an  extremely  liquid  investment  instrument.  Trade  ac- 
ceptances, which  are  usually  documented  until  payment,  sub- 
ject to  the  option  of  prepayment  by  the  acceptor,  and  which 
acquire  their  credit  rating  from  the  name  of  a  business  man, 
are  never  bought  and  sold  with  the  ease  and  at  the  low  and 
stable  rates  accorded  the  acceptances  of  banking  houses. 
This  is  not  to  say  that  the  absence  of  a  discount  market  in 
New  York  is  to  be  attributed  solely  to  the  fact  that  dollar 
bankers'  acceptances  were  unknown;  for  other  causes  con- 
tributed to  this  result.  The  fact  itself,  however,  is  evident 
without  question;  the  money-lenders  of  New  York  employed 
their  liquid  funds  in  investments  other  than  accepted  bills  of 
exchange.  The  banks  relied  principally  upon  collateral- 
secured  call  loans  to  brokers  and  traders  on  the  Stock  Ex- 
change to  equalize  their  cash  position  and  liquefy  their  assets; 
and  the  money  brokers  and  other  middlemen  were  engaged 
chiefly  in  handling  the  short-term  promissory  notes  of  the 
commercial  world.  The  accepted  bill  of  exchange  of  short 
maturity,  which  supplied  by  far  the  most  important  material 
of  the  London  discount  market,  held  an  insignificant  place 
among  the  investment  instruments  of  New  York. 

Before  proceeding  to  discuss  other  shortcomings  of  the  New 
York  market,  it  may  be  well  to  consider  how  the  inability  of 
American  bankers  to  make  acceptances,  and  the  absence  of 
an  active  discount  market,  reacted  upon  the  exchange  trans- 


n08  FOREIGN  EXCHANGE 

aoti(^ns  of  American  traders.  It  was  pointed  out  above  that 
the  former  of  these  handicaps  comj)el!ed  our  importers  to 
employ  sterhng  letters  of  credit  whenever  that  method  of 
financing  foreign  trade  was  adopted.  The  fact  that  foreign 
bankers  had  no  assurance  of  their  ability  to  discount  dollar 
acceptances  in  New  York  made  the  marketing  of  all  long  dol- 
lar bills  in  foreign  markets  very  difficult.  Bankers  })uy  long 
commercial  bills  primarily  as  cover  for  their  demand  drafts, 
intending  to  discount  the  bills  upon  arrival  and  to  carry  the 
proceeds  of  the  discount  to  the  credit  of  their  foreign  balances. 
When  unable  to  discount  such  a  bill,  the  banker  who  buys  it 
must  resign  himself  to  making  an  investment  of  the  funds  he 
advances  until  the  investment  is  liquidated  by  the  drawee's 
pa^nnent  at  maturity.  But  dealers  in  exchange  engage  only 
incidentally  in  these  investment  operations,  and  the  amount 
of  business  of  the  kind  which  they  can  do  on  a  given  capital  is 
strictly  limited;  in  the  majority  of  cases,  they  act  only  as 
middlemen,  taking  for  collection  such  bills  as  they  are  unable 
to  discount.  Because  of  the  absence  of  a  discount  market  in 
New  York,  therefore,  a  very  narrow  demand  existed  among 
foreign  bankers  for  long  bills  drawn  in  dollars,  and  this  narrow 
demand  threw  the  dollar  rates  open  to  wide  fluctuations  and 
subjected  the  drawer  to  considerable  risk  of  exchange  when- 
ever he  was  able  to  market  his  bill  at  all.  In  many  markets, 
in  fact,  dollar  rates  were  never  quoted,  the  supply  and  demand 
for  these  bills  being  so  narrow  as  scarcely  to  constitute  a  mar- 
ket. When  unable  to  sell  his  long  dollar  bills,  the  drawer  was, 
of  course,  compelled  to  wait  for  his  money  until  collection  had 
been  effected,  which  resolved  his  sale  of  goods  to  American 
buyers,  when  financed  by  long-term  dollar  bills,  into  a  credit 
transaction  of  considerable  length.  For  these  reasons,  export- 
ers in  foreign  markets  were  loath  to  accept  terms  of  sale  which 
called  for  the  drawing  of  bills  in  dollars. 

This  appears  to  be  an  appropriate  point  at  which  to  touch 
upon  the  question  of  "direct  exchange,"  concerning  which 
there  has  been  so  much  discussion  among  writers  on  foreign 
trade  financing.  The  expression  refers  to  the  practice  of 
financing  foreign  trade  by  bills  of  exchange  drawn  by  the 


THE  NEW  YORK  MARKET  S69 

exporting  market  on  the  importing  market  in  the  money  of 
the  importing  market;  or,  to  state  it  otherwise,  the  making  of 
payments  directly  between  the  two  markets  without  the  in- 
termediation of  a  third  center.  In  our  import  trade,  direct 
exchange  would  require  the  drawing  of  bills  by  the  foreign 
seller  in  dollars;  in  our  export  trade,  the  drawing  of  bills  by 
the  American  exporter  in  the  money  of  the  importer  — 
pounds,  francs,  pesos;  and  in  both  branches  of  trade  the  nego- 
tiation of  these  bills  by  the  bankers  of  the  two  markets  with- 
out help  from  the  outside.  This  practice  appears  desirable  to 
many  people  because  it  throws  the  negotiation  of  the  bills 
into  the  hands  of  American  banks  who  retain  the  profits  from 
the  service.  The  American  merchant  is  supposed  to  be  bene- 
fited by  the  practice  through  some  virtue  which  inheres  in  his 
patronage  of  a  fellow  countryman.  Without  at  present  rais- 
ing the  question  of  the  merits  of  direct  exchange,  we  are  pre- 
pared to  understand  why  the  practice  has  not  been  common 
in  the  import  trade  of  the  United  States  in  the  past. 

For  reasons  stated  in  the  preceding  paragraph,  the  foreign 
merchant  has  rarely  agreed  to  draw  upon  his  American  cus- 
tomer in  dollars;  either  he  did  not  draw  at  all  —  requiring  a 
remittance  from  the  importer  —  or  he  requested  authority  to 
draw  in  sterling  on  London.  Moreover,  when  remittances 
were  made  from  this  side,  dollar  demand  drafts  were  not  fre- 
quently employed.  In  our  import  trade  with  Europe,  re- 
mittances frequently  took  the  form  of  demand  drafts  upon 
banks  in  the  exporter's  country,  since  our  bankers  maintained 
active  balances  in  most  of  the  important  European  centers 
and  were  prepared  to  sell  drafts  against  these  balances.  Out- 
side of  Europe,  importers  usually  discharged  their  obligations 
to  make  remittances  by  sending  sterling  demand  drafts.  This 
for  a  double  reason :  American  bankers  were  prepared  to  draw 
these  drafts  in  large  volumes,  whereas  they  were  not  similarly 
prepared  with  respect  to  most  non-European  markets;  and 
the  bankers  of  our  foreign  creditors  have  always  been  willing 
to  cash  sterling  demand  drafts  because  of  the  ease  with  which 
they  found  opportunity  to  draw  against  their  London  bal- 
ances.   In  general,  therefore,  our  trade  has  not  been  financed 


870  FOREIGN  EXCHANGE 

by  direct  cxchanjxe.  The  weakness  of  the  New  York  dis- 
count market  was  chiefly  responsible  for  this  condition  of 
affairs. 

A  third  weakness  of  the  mechanism  of  the  New  York  mar- 
ket j)rior  to  the  passage  of  the  Federal  Reserve  Act  was  the 
absence  of  any  central  agency  of  rediscount:  there  was  no  in- 
stitution in  New  York  similar  in  purpose  and  function  to  the 
Bank  of  England,  the  Bank  of  France,  or  the  Reichsbank  of 
Berlin.  The  services  of  such  an  institution  to  the  money 
market  have  been  described  in  other  places  with  the  Bank  of 
England  serving  as  a  type,'  and  need  only  be  summarized 
here.  A  central  agency  of  rediscount  increases  the  readiness 
of  bankers  to  buy  acceptances  for  investment  by  affording 
them  opportunity  to  liquidate  their  assets  on  short  notice;  it 
is  able,  under  favorable  conditions,  to  regulate  the  open  mar- 
ket rates  of  discount,  to  attract  credit  from  foreign  centers, 
and  to  determine,  within  broad  limits,  the  amount  of  business 
done  in  the  market;  it  can  exert  some  control  over  the  ebb  and 
flow  of  the  gold  stock  through  its  power  to  regulate  the  rates 
of  discount.  The  New  York  market  lacked  these  services; 
and  this  gap  in  its  mechanism  was,  to  some  extent,  the  cause 
of  the  arrested  development  of  an  open  discount  market. 

In  any  discount  market,  the  loan  funds  employed  are  drawn 
principally  from  the  current  cash  balances  of  banking  estab- 
lishments, balances  which  must  be  invested  for  short  terms 
in  highly  liquid  credit  instruments.  In  London,  the  accept- 
ance has  long  been  the  premier  instrument  for  this  type  of 
investment  because  of  its  short  term,  its  security,  and  the  ever- 
present  opportunity  of  the  bankers  to  find  relief  from  an  over- 
extended position  by  rediscounting  with  the  Bank  of  England 
through  the  medium  of  the  exchange  brokers.  Consequently, 
the  London  banks  have  devoted  large  amounts  to  invest- 
ment in  acceptances,  either  by  direct  purchase  of  the  accept- 
ances for  their  own  accounts,  or  through  call  loans  extended 
to  the  brokers  on  the  collateral  security  of  acceptances.  In 
New  York,  on  the  other  hand,  the  inability  to  rediscount  has 
impaired  the  liquidity  of  acceptances  and  rendered  them  in- 
^  See  pages  334  f. 


THE  NEW  YORK  MARKET  371 

eligible  to  serve  as  investments  for  the  cash  balances  of  the 
banks,  debarring  them  for  the  same  reason  from  serving  as 
collateral  for  the  call  loans  of  brokers.  The  investment  by 
the  banks  of  their  current  balances  in  call  loans  secured  by- 
stocks  and  bonds  —  a  type  of  investment  made  eligible  for  this 
purpose  by  reason  of  the  instant  marketability  of  the  collat- 
eral —  turned  the  current  loan  funds  of  the  market  toward 
employment  either  in  the  speculative  activities  of  the  stock 
market,  or  in  the  provision  of  fixed  capital  for  the  large  cor- 
porations. 

Two  other  impediments  to  the  development  of  the  New 
York  market  should  be  considered;  namely,  the  absence  of 
foreign  branches  of  the  New  York  banks  and  the  restrictions 
placed  by  law  upon  the  operation  of  the  New  York  branches 
of  foreign  banks.  Before  the  reform  of  our  national  banking 
laws  in  1913,  national  banks  were  forbidden  to  establish 
branches  at  home  or  abroad.  The  state  banks  had,  it  is  true, 
begun  to  establish  foreign  branches  during  the  years  immedi- 
ately preceding  this  date,  and  a  few  of  the  larger  private  bank- 
ing houses  had  opened  branches  in  the  principal  European  cen- 
ters; but  the  development  of  these  foreign  connections  was,  on 
the  whole,  insignificant.  The  branch  establishments  of  foreign 
banks  in  New  York  were  hampered  by  state  laws  prohibiting 
the  acceptance  of  deposits  and  otherwise  restricting  their  oper- 
ations; both  of  these  conditions  operated  to  prevent  a  close 
union  of  New  York  with  other  money  centers.  In  contrast 
with  this  situation,  the  growth  of  foreign  branch  banking  in 
other  countries  was  striking.  Before  the  Great  War,  forty 
English  banks  operated  1325  branches  in  foreign  countries; 
five  German  banks  maintained  forty  branches  in  South  Amer- 
ica alone,  and  in  the  same  continent,  five  English  banks  had 
seventy  branches. 

Now,  it  is  possible  to  overestimate  the  importance  of  Amer- 
ican branch  banks  in  foreign  markets.  Correspondent  re- 
lations with  native  banks  afford  a  method  of  handling  foreign 
exchange  which  may  be  as  inexpensive  and  efficient  as  that  af- 
forded by  the  establishment  of  foreign  departments  by  our 
banking  houses.  It  has  been  urged  in  favor  of  the  latter  method. 


372  FOREIGN  EXCILYNGE 

that  the  reliance  of  our  traders  upon  foreij:;n  institutions  for 
the  collection  of  accounts,  and  the  handling  of  the  bills  of 
huling  and  other  documents  which  accompany  the  conmiercial 
bill  of  exchange,  has  subjected  them  to  the  betrayal  of  trade 
secrets  to  foreign  competitors.  Investigation  has  failed  to 
bring  to  light  evidence  that  this  risk  was  ever  operative  to  a 
significant  degree.  But  in  certain  respects  it  is  to  the  advan- 
tage of  business  men  to  conduct  their  exchange  transactions 
through  their  own  banks  entirely.  This  method  assures  a 
continuity  of  responsibility  on  the  part  of  the  home  banker 
which  reduces  the  client's  risk  of  loss  due  to  violation  of  in- 
structions or  mistaken  judgment  by  the  foreign  agent.  Fur- 
thermore, collecting  foreign  bills  through  the  branch  offices 
of  a  home  bank  in  many  cases  affords  better  protection  to  the 
merchandise  shipped  in  connection  with  a  documentary  bill. 
Some  countries  —  notably  in  South  America  —  are  lax  in 
requiring  the  consignee  to  present  a  bill  of  lading  in  order  to 
obtain  goods  from  the  customs  house,  and  this  practice  ma- 
terially reduces  the  value  of  the  bill  of  lading  as  security  for  a 
payment  draft.  Dealing  through  American  branches,  in  such 
cases,  assures  the  drawer  of  the  bill,  client  of  the  home  office, 
more  rigid  defense  of  his  rights.  It  is  also  probable  that  in  the 
storing  of  merchandise  and  its  release  on  trust  to  the  buyer,  the 
interests  of  the  shipper  will  be  more  carefully  conserved  when 
he  is  a  client  of  the  home  office,  of  which  the  local  bank  is  a 
branch.  Finally,  and  most  important,  the  spread  of  branch 
banks  opens  up  sources  of  credit  and  trade  information  to  the 
American  merchant  which  makes  possible  a  more  intelligent 
handling  of  his  credit  risks. 

The  competing  power  of  an  exporter  in  the  world  markets 
is  to  some  extent  conditioned  on  his  willingness  to  offer  at- 
tractive credit  terms  and  convenient  and  inexpensive  methods 
of  financing  the  sale.  From  the  standpoint  of  the  foreign 
buyer,  the  exercise  of  choice  between  competing  goods  of 
like  quality  will  turn  upon  the  question  of  cost  —  including 
the  interest  charge  involved  in  financing  his  purchase  — 
and  the  length  of  time  accorded  him  within  which  to  make 
payment.     The  readiness  of  the  average  exporter  to  extend 


THE  NEW  YORK  M.IRKET  373 

credit  to  his  foreign  customer  depends  primarily  upon  two 
factors:  access  to  reliable  and  comprehensive  sources  of  credit 
information  covering  foreign  markets;  and  the  existence  of 
machinery  through  which  to  dispose  of  his  long  bills  and  thus 
release  himself  from  the  immediate  burden  of  carrying  the 
risk.  The  cost  of  extending  the  credit  —  that  cost  which  the 
exporter  must  add  to  the  sale  price  of  his  goods  —  is  com- 
prised, not  principally  of  bankers'  commissions,  but  of  the 
discount  which  is  applied  to  his  bill  when  bought  by  the  banker, 
and  this  is  determined  by  the  efficiency  of  the  discount  mar- 
ket in  which  the  banker  disposes  of  the  bill  after  acceptance. 
The  establishment  of  foreign  branches  by  American  banks,  by 
opening  up  sources  of  credit  information  and  acquainting  the 
exporters  with  methods  of  financing  foreign  sale,  will  enable 
American  sellers  to  offer  more  liberal  credit  terms,  and,  hence, 
will  increase  their  competing  power  to  some  extent.  But  this 
development,  of  itself,  will  not  suffice  to  reduce  the  financing 
costs  of  American  exporters  —  and  the  sale  prices  of  American 
goods  —  to  an  equality  with  those  of  all  other  competitors. 
The  spread  of  foreign  branches  must  be  supplemented  by  the 
development  of  a  discount  market  as  efficient  and  inexpen- 
sive as  those  of  other  countries  before  the  credit  costs  of 
American  merchants,  who  conduct  their  transactions  through 
American  banks,  can  be  placed  on  a  par  with  those  of  his  com- 
petitors in  other  countries. 

84.  The  Federal  Reserve  Act  and  its  relation  to  the  ex- 
change market.  We  are  concerned  with  the  banking  struc- 
ture of  the  United  States  only  in  so  far  as  it  is  related  to  the 
business  of  foreign  exchange  and  the  development  of  the  ex- 
change market  in  the  United  States.  Accordingly,  we  shall 
deal  with  the  Federal  Reserve  Act  solely  from  the  point  of 
view  of  its  bearing  on  this  particular  subject.  The  Act  was 
passed  for  the  purpose  of  remedying  certain  obvious  and  long- 
standing defects  in  our  banking  mechanism;  with  regard  to 
foreign  exchange,  the  most  serious  of  these  defects,  to  recapit- 
ulate the  substance  of  the  preceding  section,  were  the  fol- 
lowing: 

(1)  The  inability  of  American  banks  to  make  acceptances. 


374  FOREIGN  EXCHANGE 

('■2)  The  absence  of  an  open  discount  market  in  which  ac- 
ceptances could  1)C  bought  and  sold. 

(3)  The  total  lack  of  a  central  agency  of  rediscount. 

(4)  The  absence  of  foreign  branches  of  American  banks. 
By  the  terms  of   the   Federal   Reserve   Act,  any  bank, 

member  of  the  Federal  Reserve  System,  is  now  empowered 
to  "accept  drafts  or  bills  of  exchange  drawn  upon  it  having 
not  more  than  six  months'  sight  to  run,  exclusive  of  days  of 
grace,  which  grow  out  of  transactions  involving  the  impor- 
tation or  exportation  of  goods;  or  which  grow  out  of  transac- 
tions involving  domestic  shipment  of  goods,*  provided  ship- 
ping documents  conveying  or  securing  title  are  attached  at 
the  time  of  acceptance;  or  which  are  secured  at  the  time  of 
acceptance  by  a  warehouse  receipt  or  other  such  documents 
conveying  or  securing  title  covering  readily  marketable  sta- 
ples." The  law  also  permits  any  member  bank  to  accept 
"drafts  or  bills  of  exchange  drawn  upon  it  having  not  more 
than  three  months'  sight  to  run,  exclusive  of  days  of  grace, 
drawn  under  regulations  prescribed  by  the  Federal  Reserve 
Board  by  banks  or  bankers  in  other  countries  for  the  pur- 
pose of  furnishing  dollar  exchange  as  required  by  the  usages 
of  trade  in  the  respective  countries."^ 

The  number  of  acceptances  which  a  member  bank  may  make 
is  limited  by  the  Act  as  follows:  Of  commercial  bills,  no  bank 
may  accept  for  any  one  drawer  an  amount  exceeding  at  any 
time  ten  per  cent  of  the  bank's  capital  and  surplus,  unless  the 
bank  is  secured  by  attached  documents  or  by  some  other 
security  growing  out  of  the  same  transaction  as  the  accept- 
ance. Even  when  thus  secured,  the  bank  may  not  accept 
these  bills  for  any  one  drawer  to  an  amount  exceeding  one  half 
of  its  capital  and  surplus.  This  limitation,  however,  may  be 
relaxed  at  the  pleasure  of  the  Federal  Reserve  Board  to  per- 
mit a  bank  to  accept  for  one  drawer  to  an  amount  equal  to 
its  capital  and  surplus,  under  regulations  prescribed  by  the 
Board.    Of  bankers'  bills,  the  number  of  acceptances  made  for 

'  The  power  to  make  acceptances  was  originally  restricted  to  foreign  bills, 
but  was  extended  to  domestic  bills  by  the  amendment  of  September  7, 1916. 
2  Amendment  to  the  Act,  1916. 


THE  NEW  YORK  MARKET  375 

any  one  drawer  is  similarly  limited  to  ten  per  cent  of  the  bank's 
capital  and  surplus  if  the  bill  is  unsecured,  and  to  fifty  per 
cent  if  the  bill  is  secured  by  documents  conveying  or  securing 
title,  or  by  some  other  security.  In  this  case,  the  Board  has 
no  power  to  relax  the  restriction.  Coincident  with  this  new 
power  of  the  national  banks  to  make  acceptances,  the  state 
laws  in  New  York  and  other  states  were  revised  to  permit  state 
banks  and  trust  companies  similar  power. 

These  new  powers  conferred  upon  our  banks  adequately 
cover  the  needs  of  the  merchants  of  the  United  States  for 
the  banker's  acceptance  as  a  financing  instrument.  Dollar 
letters  of  credit  are  now  issued  on  behalf  of  importers,  and  the 
drawing  of  long-term  dollar  bills  by  foreign  sellers  —  a  devel- 
opment stimulated  by  the  abnormal  conditions  created  by  the 
Great  War  —  has  rapidly  increased.  The  authority  of  our 
banks  to  accept  commercial  bills  has  also  been  adapted  to  the 
needs  of  our  exporters.  One  way  in  which  this  is  done  is  as 
follows :  the  exporter  assigns  to  the  bank  his  claim  against  the 
foreign  buyer  and  binds  himself  to  place  the  bank  in  funds 
before  the  maturity  of  the  acceptance;  he  is  then  permitted  to 
draw  against  the  bank  for  the  value  of  his  goods  and  to  liqui- 
date the  sale  by  discounting  the  acceptance  in  the  open  mar- 
ket. Another  method  places  upon  the  foreign  buyer  the  duty 
of  taking  the  initiative  in  providing  means  for  financing  the 
sale;  the  buyer,  through  the  medium  of  his  bank,  estab- 
lishes a  dollar  credit  in  favor  of  the  exporter,  who  draws 
against  an  American  bank  for  the  value  of  his  goods  and  ob- 
tains his  money  by  selling  the  acceptance.  In  these  transac- 
tions, the  accepting  bank,  of  course,  merely  lends  its  credit;  the 
funds  with  which  the  transactions  are  financed  are  drawn  from 
the  discount  market  when  the  acceptance  is  sold,  and  it  is 
upon  the  adequacy  of  these  funds  to  absorb  the  acceptances 
made  by  our  banks  that  the  efficiency  of  the  dollar  banker's 
acceptance  as  a  financing  instrument  in  foreign  trade  is  con- 
ditioned. 

It  should  be  apparent  that  the  absence  of  a  discount  mar- 
ket for  acceptances  could  not  be  entirely  corrected  by  legis- 
lation.   The  law  can  create  conditions  favorable  to  the  devel- 


876  FOREIGN  EXCHANGE 

opnicnt  of  such  a  market  by  removing  obstacles  which  for- 
merly hindered  its  growth,  but  the  practice  of  investing  cur- 
rent funds  in  acceptances  in  preference  to  their  investment 
in  short-term  instruments  of  other  kinds  must  be  left  to  the 
initiative  of  the  money-lenders  acting  under  the  spur  of  self- 
interest.  We  shall  postpone  our  discussion  of  the  develop- 
ment of  the  discount  market  in  New  York  to  the  following 
section,  proceeding  at  this  point  to  examine  other  features  of 
the  PVderal  Reserve  Act  which  have  operated  to  favor  the 
growth  of  the  discount  market. 

The  tliird  of  our  list  of  obstacles  to  the  development  of 
New  York  as  a  world  center  of  foreign  exchange  has  been  re- 
moved: the  law  has  created  machinery  for  rediscounting  the 
assets  of  the  banks.  Twelve  institutions  have  been  estab- 
lished for  this  purpose,  each  serving  directly  the  needs  of  its 
prescribed  district,^  the  entire  system  being  drawn  together 
through  powers  granted  each  Reserve  Bank  to  take  over  the 
assets  of  another  under  regulations  laid  down  by  the  Federal 
Reserve  Board.  Not  all  kinds  of  commercial  paper  are  el- 
igible for  rediscount  by  the  Federal  Reserve  Banks.  The 
language  of  the  law  covering  this  point  is  as  follows: 

Upon  endorsement  of  any  of  its  member  banks,  which  shall  be 
deemed  waiver  of  demand,  notice,  and  protest  by  such  bank  as  to 
its  own  endorsement  exclusively,  any  Federal  Reserve  Bank  may  dis- 
count notes,  drafts,  and  bills  of  exchange  arising  out  of  actual  com- 
mercial transactions;  that  is,  notes,  drafts,  and  bills  of  exchange  is- 
sued or  drawn  for  agricultural,  industrial,  or  commercial  purposes, 
or  the  proceeds  of  which  have  been  used,  or  are  to  be  used,  for 
such  purposes,  the  Federal  Reserve  Board  to  have  the  right  to  de- 
termine or  define  the  character  of  the  paper  thus  made  eligible  for 

*  These  institutions  are  called  the  Federal  Reserve  Banks.  They  are  lo- 
cated throughout  the  country  as  follows: 


District 

City 

District 

City 

1 

Boston 

7 

Chicago 

9 

New  York 

8 

St.  Louis 

3 

Philadelphia 

9 

Minneapolis 

4 

Cleveland 

10 

Kansas  City 

5 

Richmond 

11 

Dallas 

6 

Atlanta 

12 

San  Francisco 

THE  NEW  YORK  MARKET  S77 

discount,  within  the  meaning  of  this  Act.  Nothing  in  this  act  con- 
tained shall  be  construed  to  prohibit  such  notes,  drafts,  and  bills  of 
exchange  secured  by  staple  agricultural  products,  or  other  goods, 
wares,  or  merchandise  from  being  eligible  for  such  discount;  but 
such  definition  shall  not  include  notes,  drafts,  or  bills  covering 
merely  investments  or  issued  or  drawn  for  the  purpose  of  carrying 
or  trading  in  stocks,  bonds,  or  other  investment  securities,  except 
bonds  and  notes  of  the  United  States  Government.  Notes,  drafts, 
and  bills  admitted  to  discount  under  the  terms  of  this  paragraph 
must  have  a  maturity  at  the  time  of  discount  of  not  more  than 
ninety  days,  exclusive  of  days  of  grace;  Provided,  that  notes,  drafts, 
and  bills  drawn  or  issued  for  agricultural  purposes  or  based  on  live 
stock  and  having  a  maturity  not  exceeding  six  months,  exclusive  of 
days  of  grace,  may  be  discounted  in  an  amount  to  be  limited  to  a 
percentage  of  the  assets  of  the  Federal  Reserve  Bank,  to  be  ascer- 
tained and  fixed  by  the  Federal  Reserve  Board. 

In  discharge  of  the  duty  laid  upon  it  by  the  terms  of  the 
Act,  the  Federal  Reserve  Board  has  defined  commercial  paper 
eligible  for  rediscount  as  paper  which  arises  from  some  step  in 
the  production,  manufacture,  or  distribution  of  goods.  ^  For 
our  purposes,  this  definition,  in  conjunction  with  the  negative 
prescriptions  of  the  law  as  stated  in  the  preceding  paragraph, 
is  significant  in  that  it  admits  to  rediscount  all  bills  of  ex- 
change which  represent  the  importation  or  exportation  of 
commodities;  at  the  same  time,  discriminating  against  those 
loans  made  by  the  banks  to  finance  the  activities  of  the  stock 
market  or  for  the  purpose  of  permanent  investment  by  the 
borrower.  This  encourages  the  employment  of  current  cash 
balances  by  the  banks  in  the  purchase  of  acceptances  in  pref- 
erence to  their  employment  in  call  loans  secured  by  collateral 
of  stock  and  bonds,  and  thus  tends  to  broaden  the  demand  for 
bills  of  exchange  in  the  open  market.  With  this  superiority, 
the  acceptance  has  become  in  New  York  what  it  has  long  been 
in  London  —  an  attractive  instrument  for  equalizing  the 
cash  position  of  the  banks. 

The  law  limits  the  amount  of  paper  bearing  the  signature  or 
endorsement  of  any  one  borr(nver  which  the  R(^serve  banks 
may  discount  for  any  one  bank  to  ten  per  cent  of  the  borrow- 
^  Regulation  of  the  Federal  Reserve  Board  issued  January  25,  1915. 


878  FOREIGN  EXCHANGE 

in^  bank's  capital  and  surplus;  this  limitation,  however,  is 
waived  in  the  case  of  bills  of  exchange  drawn  in  good  faith 
against  actually  existing  values  —  for  example,  the  commer- 
cial long  bill  as  it  is  commonly  drawn  in  international  com- 
merce. The  banks  of  the  country  which  are  members  of  the 
Federal  Reserve  System'  may,  therefore,  freely  invest  their 
funds  in  acceptances  of  a  maturity  not  longer  than  ninety 
days,  with  confidence  in  their  ability  to  dispose  of  their  hold- 
ings of  such  bills  in  case  of  need.  Furthermore,  the  facilities 
of  the  member  banks  to  find  relief  from  an  over-extended 
position  have  been  improved  by  an  amendment  to  the  Act  in 
1917  which  permits  any  Federal  Reserve  Bank  to  make  ad- 
vances to  the  member  banks  against  their  promissory  notes 
for  periods  not  exceeding  fifteen  days,  provided  such  jjromis- 
sory  notes  are  secured  by  notes,  drafts,  or  bills  of  exchange 
which  are  eligible  for  rediscount,  or  by  the  obligations  of  the 
Government. 

Further  encouragement  is  given  to  the  foreign  exchange 
operations  of  our  banks  by  a  clause  in  the  Federal  Reserve 
Act  permitting  the  establishment  of  foreign  branches  by  na- 
tional banks  having  a  minimum  capital  of  $1,000,000,  with 
the  consent  of  the  Federal  Reserve  Board.  Banks  of  this  size 
are  also  permitted  to  invest  an  amount  not  exceeding  ten  per 
cent  of  their  capital  and  surplus  in  any  financial  corporation 
engaged  in  international  banking.  The  McClean  and  Edge 
Acts,2  passed  at  a  later  date,  increased  the  power  of  the  banks 
to  cooperate  in  conducting  foreign  exchange  and  foreign 
financing  transactions,  and  extended  the  privilege  to  a  wider 
group  of  banks  than  that  delimited  by  the  Federal  Reserve 
Act.  Availing  themselves  of  this  new  power,  a  few  of  the 
larger  national  banks  have  established  branches  abroad, 
especially  in  Europe  and  South  America.  State  banks  have 
taken  part  in  the  same  movement;  and  certain  large  financial 

^  All  national  banks  of  the  country  are  de  facto  members  of  the  Federal 
Reserve  System,  and  the  law  permits  state  banks  to  become  members  by 
submitting  to  an  examination  by  the  Federal  Reserve  Board  and  conforming 
to  rulings  of  the  Board.  Only  a  small  proportion  of  the  state  banks  have 
availed  themselves  of  this  opportunity  to  become  members  of  the  system. 

*  For  a  discussion  of  these  laws  see  pages  311-12. 


THE  NEW  YORK  MARKET  379 

corporations,  owned  principally  by  member  banks  of  the 
Federal  Reserve  System,  have  opened  branches  in  the  West 
Indies,  Central  and  South  America,  the  Far  East,  India  and 
the  Levant,  and  in  Europe.  These  branches  and  agencies  are 
subject  to  the  laws  of  the  countries  in  which  they  are  located; 
by  following  the  banking  practices  of  these  countries,  they 
help  to  familiarize  American  business  men  who  deal  with  their 
home  ofBces  with  the  financing  methods  of  foreign  markets 
and  with  their  own  rights  and  duties  in  connection  with  ex- 
change operations  with  these  markets. 

The  Federal  Reserve  Board  is  also  empowered  to  permit  the 
Reserve  banks  (as  distinct  from  the  member  banks  of  the 
system)  "to  open  and  maintain  accounts  in  foreign  countries, 
appoint  foreign  correspondents,  and  establish  agencies  in 
such  countries  wheresoever  it  may  deem  best  for  the  purpose 
of  purchasing,  selling,  and  collecting  bills  of  exchange,  and  to 
buy  and  sell,  with  or  without  its  endorsement  through  such 
correspondents  or  agencies,  bills  of  exchange  arising  out  of 
actual  commercial  transactions  which  have  not  more  than 
ninety  days  to  run,  exclusive  of  days  of  grace,  and  which  bear 
the  signature  of  two  or  more  responsible  parties,  and  with  the 
consent  of  the  Federal  Reserve  Board  to  open  and  maintain 
banking  accounts  for  such  correspondents  or  agencies."  The 
Federal  Reserve  Bank  of  New  York  has  acted  extensively 
under  this  power.  Correspondent  relations  have  been  formed 
with  the  Bank  of  England,  the  Bank  of  France,  and  the  Bank 
of  Italy;  with  the  Bank  of  Japan,  the  Philippine  National 
Bank,  and  the  Banks  of  Sweden,  Norway,  and  the  Nether- 
lands. Agreements  have  also  been  made  with  the  Argentine 
Government  and  the  Government  of  Peru,  covering  opera- 
tions of  limited  scope;  and  the  British  Government  has  made 
arrangements  to  supply  the  Federal  Reserve  Bank  of  New 
York  each  month  with  sufficient  rupee  exchange  to  satisfy 
the  requirements  of  American  importers  from  India.  This 
development  of  branch  banking  by  the  national  and  state 
banks,  and  of  close  correspondent  relations  with  foreign 
banks  and  governments  by  the  Federal  Reserve  Bank  of  New 
York,  has  brought  the  New  York  market  into  closer  union 


380  FOREIGN  EXCHANGE 

with  the  principal  financial  and  trading  centers  of  the  world 
than  l)efore.  Though  the  development  of  foreign  branch 
banking  has  not  yet  attained  dimensions  comparable  to  the 
world-wide  contacts  of  the  English  and  German  banks  before 
the  Great  War,  the  restoration  of  normal  conditions  will  prob- 
ably accelerate  its  pace. 

85.  The  present  mechanism  of  the  open  market  in  New 
York.  Since  bankers'  and  trade  acceptances  do  not  repre- 
sent advances  of  funds  bj'^  the  accepting  parties,  these  instru- 
ments cannot  function  as  financing  agencies  in  the  absence 
of  a  money  market  in  which  they  can  be  sold  to  investors. 
Such  a  market  cannot  be  called  into  existence  by  law,  but 
must  wait  upon  the  development  of  banking  and  investment 
practices  which  turn  the  liquid  funds  of  a  money  center 
toward  the  purchase  of  acceptances  in  preference  to  other 
short-term  investments.  In  the  United  States,  the  open 
market  for  bills  of  exchange  developed  subsequent  to,  and 
largely  as  a  consequence  of,  the  changes  in  American  banking 
practice  recorded  in  the  preceding  section.  It  has  made  ex- 
tremely rapid  progress  as  greater  familiarity  with  the  accept- 
ance has  acquainted  money-lenders  with  its  superiorities  as  a 
safe  and  convertible  short-term  investment  instrument.  The 
acceptance  of  bills  of  exchange  by  American  bankers  began  in 
1915,  in  which  year  the  Federal  Reserve  Bank  of  New  York 
reported  the  purchase  of  only  $93,000  worth  of  acceptances  of 
all  varieties.  On  April  31,  1921,  according  to  the  Bulletin  of 
the  Federal  Reserve  Bank  of  New  York,  there  were  outstand- 
ing about  $1,000,000,000  in  bankers'  acceptances;  the  major 
proportion  of  these  (the  exact  figures  are  not  known)  arose 
from  the  foreign  commerce  of  the  country. 

In  approaching  our  study  of  the  discount  market  in  which 
these  acceptances  are  bought  and  sold,  certain  cautions  must 
be  kept  before  the  mind.  In  the  first  place,  although  the 
American  market  for  acceptances  centers  in  New  York  as 
that  of  England  centers  in  London,  Boston,  Chicago,  San 
Francisco,  and  other  financial  cities  of  the  country  are  de- 
veloping markets  which  follow  the  same  lines  as  that  of  New 
^Yprk.  but  on  a  smaller  scale.     In  limiting  our  inquiry  to  the 


THE  NEW  YORK  MARKET  881 

New  York  market,  therefore,  it  must  not  be  understood  that 
that  city  constitutes  the  sole  discount  market  of  the  country, 
but,  rather,  that  it  is  the  chief  market  and  the  prototype  of 
the  others.  In  the  second  place,  it  must  be  remembered  that 
the  New  York  market  has  not  yet  attained  a  settled  and 
stable  structure  which  make  precise  and  comprehensive  de- 
scription possible.  Its  experience  has  been  solely  with  ab- 
normal times,  when  conditions  were  unsettled  either  by  the 
Great  War  and  the  world-wide  depression  which  followed  it, 
or  by  its  own  immaturity  and  rapid  development.  Conse- 
quently, the  description  which  follows  must  be  understood  to 
apply  only  to  current  and  rapidly  changing  conditions. 

We  can  best  proceed  by  separating  the  machinery  of  the 
market  into  two  major  divisions:  (a)  the  creators  of  the  ac- 
ceptances in  which  the  market  deals;  (6)  the  investment 
machinery  of  the  open  market  through  which  funds  are  ad- 
vanced to  purchase  these  acceptances.  Concerning  the  for- 
mer of  these  divisions,  little  description  is  necessary.  The 
trade  acceptance  has,  of  course,  never  been  illegal  in  the 
United  States,  though  its  use  prior  to  1914  was  very  rare.  In 
domestic  trad«,  business  custom  had  developed  the  almost 
exclusive  use  of  "commercial  paper"  —  the  single  name 
"promissory  note"  —  as  the  typical  short-term  financing 
instrument;  in  foreign  trade,  for  reasons  which  have  been 
given,  the  trade  bill  drawn  in  dollars  was  equally  rare.  The 
dollar  trade  acceptance  is  now  being  used,  not  so  much  as  the 
result  of  legal  changes  as  of  an  educational  campaign  among 
American  business  men;  though  the  eligibility  of  these  accept- 
ances to  rediscount  (when  endorsed  by  a  member  bank)  has 
certainly  increased  the  demand  for  them.  In  domestic  trade, 
the  increase  in  the  use  of  trade  acceptances  has  been  especially 
marked;  in  foreign  trade,  they  do  not  rank  with  the  bankers' 
acceptance,  though  their  use  is  not  unknown. 

The  making  of  dollar  bankers'  acceptances  is  more  directly 
the  result  of  the  legal  changes  which  we  have  been  describing. 
There  are  now  a  number  of  finance  houses,  formed  principally 
from  capital  supplied  by  bankers  and  other  financiers,  or- 
ganized for  the  express  purpose  of  making  these  acceptances. 


SSe  FOREIGN  EXCHANGE 

These  institutions  do  not  conduct  .1  general  banking  business 
nor  carry  on  open  market  operations,  but  exist  solely  for  the 
purpose  of  lending  their  names  as  accei>tors  of  long  dollar 
bills  drawn  by  merchants  and  bankers,  after  the  practice  of 
the  old  acceptance  houses  of  London.  The  number  of  these 
finance  houses  is  increasing.  But  for  the  most  part,  the  ac- 
cepting of  bills  of  exchange  is  done  by  the  banks  —  national 
banks,  members  of  the  Federal  Reserve  System,  state  banks 
and  trust  companies  —  under  the  powers  recently  conferred 
upon  them.  The  relationship  of  these  banks  to  their  foreign 
correspondents  does  not  greatly  differ  from  similar  relation- 
ships of  the  London  banks,  described  in  detail  in  the  preceding 
chapter.  The  American  banks  undertake  to  handle  the  long 
dollar  bills  bought  or  taken  for  collection  by  their  correspond- 
ents, obtaining  acceptances  on  these  bills  and  discounting 
them  on  the  open  market,  or  holding  them  until  maturity 
according  to  instructions  from  abroad.  In  the  second  place, 
they  accept  long-term  dollar  bills  drawn  upon  them  either  by 
the  foreign  correspondent  or  by  some  one  else  under  authority 
of  a  dollar  letter  of  credit  issued  by  the  correspondent. 
Thirdly,  they  undertake  to  cash  across  the  counter,  out  of 
balances  maintained  with  them  by  the  foreign  bank,  dollar 
demand  drafts  and  cables  sold  abroad.  These  transactions 
require  the  correspondent  to  maintain  with  the  New  York 
bank  an  acceptance  account  and  a  cash  balance,  and  it  is 
in  connection  with  their  duties  with  regard  to  the  acceptance 
account  that  the  New  York  banks  become  the  creators  of 
dollar  acceptances  of  foreign  origin.  The  management  of 
these  accounts,  the  duties  involved  in  their  maintenance,  and 
the  charges  made  by  the  New  York  banks  for  services  ren- 
dered with  regard  to  them,  are  substantially  the  same  as 
those  discussed  in  our  description  of  the  London  market  and 
need  not  be  considered  in  detail  in  this  place.  ^ 

The  machinery  of  the  open  market  through  which  funds  are 
advanced  in  the  purchase  of  acceptances  comprises  the  follow- 
ing groups:  (1)  the  primary  buyers  of  acceptances —  investors 
who  buy  acceptances  on  their  own  account  for  the  gain  of 
^  See  page  314. 


THE  NEW  YORK  MARKET  383 

interest;  (2)  the  middlemen  or  brokers  who,  without  consider- 
able investment  of  their  own  funds,  bring  buyer  and  seller 
together;  (3)  the  secondary  buyer —  the  Federal  Reserve 
Bank  to  whom  investors  resell  their  holdings.  This  classifica- 
tion is  made  in  full  knowledge  of  the  fact  that  these  different 
groups  are  not  at  present  mutually  exclusive  in  function. 
The  second  and  third  groups  discharge  in  part  the  functions 
of  the  first;  brokers  are  to  some  extent  investors  on  their  own 
account,  and  the  Federal  Reserve  Bank,  in  theory  a  strictly 
rediscounting  agency,  has  always  been  a  large  buyer  of  bills  in 
the  open  market.  However,  the  separation  of  function  im- 
plied in  the  division  is  growing  more  sharply  defined  as  the 
market  develops,  and  the  structure  of  the  market  will  prob- 
ably approximate  more  and  more  closely  this  grouping  of 
interdependent  organs  as  time  passes. 

86.  Primary  investors  in  the  open  market  of  New  York. 
It  is  upon  the  numter  of  primary  investors,  and  the  volume  of 
loan  funds  which  they  bring  forward  for  investment,  that  the 
efficiency  of  the  market  is  chiefly  dependent.  Given  a  large 
and  constantly  renewed  stream  of  loan  funds  converging  on 
the  market,  and  active  competition  between  great  numbers  of 
buyers,  low  and  stable  rates  of  discount  can  be  maintained; 
and  bankers  in  foreign  cities  can  negotiate  dollar  bills  with 
confidence  in  their  ability  to  recover  their  funds  at  a  prede- 
termined cost  through  access  to  the  open  discount  market  in 
New  York.  At  present,  the  primary  buyers  of  liilLs  comprise 
a  mixed  group  of  money-lenders.  First  of  all  are  the  great 
commercial  banks  of  the  city;  in  the  second  place,  the  dis- 
count and  finance  houses  which  have  been  organized  by  finan- 
ciers for  the  purpose  of  investing  funds  through  the  discount 
market;  thirdly,  a  miscellaneous  group  of  money-lenders — ■ 
savings  banks,  insurance  companies,  corporations,  private 
individuals  —  who  enter  the  market  from  time  to  time  to  give 
employment  to  occasional  cash  balances  whose  investment 
must  be  liquid;  finally,  the  Federal  Reserve  Bank,  for  reasons 
which  shall  be  explained,  buys  bills  in  the  open  market. 
Through  these  various  channels  current  loan  funds  flow  to  the 
New  York  market  from  different  sections  of  the  country. 


384  FOREIGN  EXCHANGE 

The  commercial  hanks  arc  constantly  adding  to  their  lists  of 
out-of-town  customers  for  whose  accounts  they  are  instructed 
to  buy  acceptances  from  day  to  day.  The  Federal  Reserve 
IBank  of  New  York  has  also  bought  largely  for  the  account  of 
Reserve  Banks  in  other  cities;  in  1919,  for  example,  out  of  a 
total  purchase  of  acceptances  to  the  value  of  $1,950,898,000, 
the  Reserve  Bank  of  New  York  distributed  $739,499,000  as 
follows: 

Cleveland $179,592,000 

Chicago 160,173,000 

St.  Louis 500,000 

Minneapolis 88,696,000 

Kansas  City 22,461,000 

San  Francisco 288,077,000 

This  broadening  of  the  market  at  once  increases  the  supply 
and  diversifies  the  sources  of  the  loan  funds  which  are  em- 
ployed in  New  York,  thus  producing  the  double  effect  of  mul- 
tiplying the  capacity  of  the  market,  and  defending  it  from 
sudden  changes  in  demand  which  might  cause  violent  fluctu- 
ations of  the  rates  of  discount. 

The  commercial  banks  of  New  York  have  begun  only  re- 
cently to  invest  funds  in  the  discount  market.  As  stated  in 
another  place,  it  had  long  been  their  practice  to  invest  that 
part  of  their  funds  which  must  be  kept  liquid  in  the  call  money 
market  where  loans  are  extended  for  periods  of  twenty-four 
hours  against  deposits  of  stocks  and  bonds.  This  practice 
was  made  possible  by  the  policy  of  daily  settlement  of  the 
Stock  Exchange  which  enabled  brokers  and  speculators  to 
finance  their  operations  by  means  of  these  short-time  loans. 
But  the  fact  that  the  practice  was  so  general  among  the  banks 
is  to  be  attributed  to  the  lack  —  before  the  legalizing  of  the 
banker's  acceptance  —  of  any  other  form  of  investment  which 
would  be  at  once  liquid  and  secure.  In  London,  fortnightly 
settlement  by  the  Stock  Exchange  reduces  the  demand  for 
call  loans  for  speculative  purposes,  while  long  acquaintance 
with  the  banker's  acceptance  has  developed  a  firmly  rooted 
preference  among  bankers  for  the  discount  market  as  an  out- 


THE  NEW  YORK  MARKET  S85 

let  for  their  current  funds.  Although  New  York  bankers,  to 
an  increasing  extent,  are  breaking  away  from  the  methods  of 
the  past  and  adopting  the  London  practice,  the  call  money 
market  still  competes  with  the  discount  market;  when  the 
call  rates  rise,  funds  are  diverted  from  the  bill  market,  and 
turned  back  into  the  bill  market  when  they  fall.  In  conse- 
quence of  this  interdependence  of  the  supplies  of  funds  in  the 
two  markets,  the  call  money  rate  and  the  rate  of  discount  are 
mutually  related,  tending  to  rise  and  to  fall  in  sympathy  with 
each  other.  The  bill  market  cannot  become  in  New  York 
what  it  is  in  London —  the  heart  of  the  credit  structure —  as 
long  as  it  shares  with  the  Stock  Exchange  command  over  the 
liquid  funds  of  the  banks. 

The  banks  hold  a  two-sided  relationship  with  the  open 
market:  they  both  sell  and  buy  bills  of  exchange.  In  dis- 
charging the  duties  involved  in  their  correspondent  agree- 
ments, or  in  their  relations  with  their  foreign  branches,  Amer- 
ican banks  receive  by  every  mail  remittances  of  long  dollar 
bills  to  be  presented  for  acceptance  and  discounted  in  the  open 
market.  The  New  York  branches  of  foreign  banks  are  also 
engaged  in  these  activities.  When,  acting  in  this  capacity, 
the  banks  of  New  York  appear  upon  the  supply  side  of  the 
market,  they  occasionally  place  the  bills  which  they  have  for 
sale  directly  in  the  hands  of  some  other  primary  investor  — 
either  their  own  client,  or  another  bank  or  finance  house; 
more  frequently,  however,  they  make  the  sale  through  the 
bill  brokers. 

As  buyers  of  bills,  the  banks  draw  acceptances  from  two 
sources:  the  remittances  received  through  the  mails  from 
foreign  correspondents  and  branches;  and  the  offerings  of  the 
bill  brokers.  The  duty  of  the  New  York  banker  to  his  for- 
eign correspondent  requires  him  to  sell  the  acceptance  at  the 
best  rate  obtainable  in  the  market,  but  does  not  debar  him 
from  paying  this  rate  himself  and  obtaining  the  bill  for  his 
own  account.  An  incidental  advantage  to  the  banker  from 
his  foreign  connections  is  this  opportunity  to  select,  from  a 
large  and  continuous  stream  of  bills,  those  whose  amount, 
security,  and  term  of  life  suit  them  to  the  needs  of  the  bank- 


886  FOREIGN  EXCHANGE 

cr's  portfolio.  That  this  opportunity  is  of  real  value  to  the 
banker  is  evident  from  the  faet  that  he  is  accustomed  to  pay- 
ing a  commission  charge  for  this  very  service  of  supplying  a 
classified  selection  of  instruments  when  dealing  with  the  bro- 
kers. The  majority  of  the  banks,  however,  do  not  enter  into 
correspondent  relations  with  foreign  markets;  this  larger 
group  of  banks  l)uy  bills  directly  from  the  brokers  who  act  as 
middlemen  in  the  market,  or,  occasionally,  from  their  own 
clients. 

The  other  'primary  investors  in  the  hill  market,  with  the  ex- 
ception of  the  Federal  Reserve  Bank  whose  open  market 
operations  will  be  discussed  on  a  later  page,  may  be  thrown 
into  a  common  group.  There  have  always  existed  in  New 
York  a  large  number  of  private  investment  houses  accus- 
tomed to  buying  commercial  paper  and  similar  short-term 
investment  instruments;  many  of  these  have  now  opened 
departments  for  dealing  in  acceptances.  New  discount 
houses  have  also  been  formed  with  large  capital  for  the  specific 
purpose  of  operating  in  the  bill  market,  buying  acceptances 
and  holding  them  until  maturity,  or  selling  them  again  with 
or  without  their  endorsement.  These  institutions  mark  the 
beginnings  of  a  line  of  development  which  in  London  has  led 
to  the  establishment  of  powerful  discount  houses  which  sup- 
ply a  considerable  proportion  of  the  liquid  capital  of  that 
great  money  center.  But  up  to  the  present,  the  American 
discount  houses  have  differed  from  their  English  counterparts 
in  that  it  has  been  their  policy  to  turn  over  their  assets  rap- 
idly, reselling  their  acceptances  whenever  market  conditions 
were  favorable;  whereas  the  discount  houses  of  London  almost 
invariably  carry  their  holdings  of  acceptances  through  to 
maturity.  In  addition  to  these  institutions,  other  primary 
investors  have  been  attracted  by  the  opportunities  of  the 
discount  market.  Some  of  the  states  have  amended  their 
laws  to  permit  savings  banks  and  trust  companies  to  invest 
in  bankers'  acceptances;  corporations  and  estates  with  excess 
funds  for  short  periods,  and  individual  money-lenders,  are 
learning  the  merits  of  the  acceptance  as  an  investment  oppor- 
tunity.    The  funds  drawn  into  the  market  from  these  differ- 


THE  NEW  YORK  MARKET  387 

ent  and  widely  scattered  sources  are  continually  adding  to 
the  financial  strength  of  New  York  and  increasing  the  ability 
of  the  city  to  withstand  the  strain  put  upon  it  by  the  use  of 
dollar  credits  in  international  commerce. 

87.  The  New  York  bill  brokers.  The  principal  function  of 
the  brokers  is  to  provide  a  connecting  link  between  the  sellers 
of  acceptances  and  the  primary  buyers.  In  performing  this 
function,  they  do  not  act  as  investors  or  suppliers  of  capital 
to  any  great  extent,  but  merely  as  middlemen.  Their  day's 
work  consists  in  making  the  rounds  of  the  banks,  discount 
houses,  and  other  sources  of  supply  and  demand  for  bills  of 
exchange,  ascertaining  in  each  instance  what  bills  are  offered 
for  sale  and  what  bills  are  in  demand,  and  then  supplying  the 
needs  of  the  buyers  by  taking  up  and  distributing  the  bills 
offered  by  the  sellers.  The  brokers  are  also  sought  out  by 
business  firms  and  individuals  who  have  acceptances  for  sale 
in  connection  with  some  mercantile  transaction,  and  are  en- 
gaged to  find  buyers  for  these  acceptances.  In  the  last- 
named  type  of  operation,  the  bill  broker  invests  no  capital  at 
all  in  the  instruments  in  which  he  deals,  but  simply  brings 
buyer  and  seller  together  by  undertaking  to  place  the  seller's 
bill  in  the  hands  of  an  investor  and  return  to  the  seller  the 
proceeds  of  the  discount  minus  a  small  commission.  As  mid- 
dlemen, the  importance  of  the  brokers  lies  in  the  service  they 
render  by  sorting  the  miscellaneous  bills  of  the  sellers,  and 
offering  them  properly  classified  to  meet  the  peculiar  needs 
of  each  investor.  This  service  increases  the  ease  with  which 
bills  are  bought  and  sold,  broadens  the  market,  and  stabilizes 
the  rates;  the  commission  earned  by  the  broker  is  a  modest 
charge  for  a  service  of  such  importance. 

But  these  activities  of  the  middleman  do  not  represent  the 
whole  function  of  the  bill  brokers.  Many,  if  not  all,  of  the 
brokers  in  the  open  market  bring  forward  capital  of  then-  own 
and  thus  create  a  part  of  the  demand  for  acceptances.  In 
dealing  with  the  larger  commercial  banks,  those  which  have 
formed  foreign  connections  and  have  developed  the  business 
of  suijjjiying  acceptances  to  the  market,  the  brokers  cus- 
tomarily acquire  ownership  of  the  acceotauces  by  outright 


888  FOREIGN  EXCHANGE 

purchase.  This  necessitates  a  command  over  a  certain 
amount  of  working  capital.  A  part  of  this  working  capital  is 
supplied  by  the  brokers  out  of  their  own  resources;  another 
part  is  borrowed  at  call  from  the  banks  on  the  security  of  the 
acceptances  which  the  brokers  carry  in  their  portfolios.  Some 
of  the  larger  banks  of  New  York  make  the  statement  that 
they  have  ceased  entirely  to  lend  at  call  to  operators  on  the 
Stock  Exchange,  and  have  made  it  their  policy  to  cater  solely 
to  the  business  of  the  bill  brokers.  But,  on  the  whole,  this 
practice  of  extending  call  loans  on  the  security  of  acceptances 
is  still  in  a  rudimentary  stage  of  development  in  the  New 
York  market,  and  the  brokers  of  that  market  have  not  as  yet 
found  access  to  that  abundance  of  liquid  credit  which  is  at 
the  command  of  the  brokers  of  London. 

It  is  the  policy  of  the  brokers  in  New  York  to  resell  quickly 
the  bills  they  have  bought.  The  turnover  of  their  capital  is 
rapid;  and  the  acceptances  found  in  their  portfolios  are  but 
momentarily  lodged  there  on  the  way  into  the  hands  of  a  more 
permanent  investor.  However,  a  net  addition  to  the  demand 
of  the  open  market  may  be  attributed  to  the  brokers,  equal  to 
the  number  of  bills  which  they  own  at  any  given  time,  ir- 
respective of  their  intentions  regarding  the  final  disposition  of 
these  bills.  But  it  must  be  remembered  that  the  brokers  buy 
these  bills  only  because  they  are  confident  of  their  ability  to 
sell  them  again  to  others;  in  other  words,  their  demand  for 
acceptances  is  contingent  upon  the  demand  of  some  other 
group  of  money  lenders,  and  would  not  exist  but  for  the 
demand  of  this  other  group .  Underlying  the  market,  there- 
fore, and  forming  the  foundation  upon  which  the  activities 
of  the  brokers  are  conducted,  are  the  banks,  discount  houses, 
and  other  true  investors,  willing  to  advance  money  upon  the 
security  of  accepted  bills  of  exchange  for  the  gain  of  interest. 
These  ultimate  investors  form  one  of  the  two  essentials  of 
the  discount  market;  the  suppliers  of  bills  form  the  other 
essential;  the  brokers'  activities  are  incidental  to  the  func- 
tioning of  these  more  fundamental  parts  of  the  machinery 
of  the  market. 

From  this  brief  description  of  the  activities  of  the  bill  bro- 


THE  NEW  YORK  MARKET  389 

kers,  it  will  be  seen  that  the  banks  hold  toward  them  a  two- 
sided  relationship;  they  supply  the  brokers  with  most  of  the 
bills  in  which  they  deal,  and  also  afford  them  the  best  market 
in  which  to  sell  these  bills.  There  is  a  slight  discrepancy  be- 
tween the  rates  at  which  the  banks  sell  to,  and  buy  from,  the 
brokers,  the  selling  rate  being  sufficiently  higher  than  the 
buying  to  afford  the  brokers  a  small  margin  of  profit.  In  the 
spring  of  1921,  for  example,  the  spread  between  the  rate  of 
discount  used  by  the  banks  when  selling  acceptances  and  the 
rate  used  when  buying  varied  between  1/8  and  1/16  per  cent; 
that  is,  when  buying  from  the  banks,  the  brokers  discounted 
an  acceptance  at  tHe  rate,  say,  of  5  3/4  per  cent,  and,  when 
selling  to  the  banks,  discounted  the  same  acceptance  at  the 
rate  of  5  11/16  per  cent.  It  need  scarcely  be  explained  that 
the  higher  the  rate  of  discount  applied  to  a  bill,  the  lower  its 
sale  price,  and  the  lower  the  rate  of  discount,  the  higher  its 
price;  hence,  by  buying  at  the  higher  rate  of  discount  and  sell- 
ing at  the  lower,  the  brokers  paid  for  their  acceptances  some- 
what less  than  they  received  for  them.  But  the  margin  of 
profit  allowed  by  a  difference  of  l/l6  per  cent  between  buying 
and  selling  rates  is  very  small,  indeed;  the  life  of  a  typical 
acceptance  is  ninety  days,  and  a  commission  of  l/l6  per  cent 
'per  year  on  an  assortment  of  bills  whose  average  life  is  ninety 
days  is  equivalent  to  a  commission  of  1/64  per  cent  on  the 
face  value  of  the  amount  handled.  This  charge  by  the  bro- 
kers would  be  considered  no  more  than  a  reasonable  profit  in 
the  discount  markets  of  Europe  which  have  had  many  more 
years  in  which  to  develop. 

The  services  which  the  brokers  render  in  return  for  their 
profit  have  been  explained  in  part.  In  London,  where  the 
relationship  between  banks  and  brokers  in  the  money  market 
is  much  the  same  as  in  New  York,  the  bills  which  the  banks 
buy  have  gained  in  desirability  in  passing  through  the  bro- 
kers' hands;  the  London  brokers  always  endorse,  either  by 
attaching  their  signatures  to  the  bills  or  (more  frequently)  by 
giving  the  banks  a  blanket  guaranty  covering  all  items  bought 
from  the  broker.  But  in  New  York,  the  brokers  do  not  en- 
dorse and,  consequently,  the  bill  gains  nothing  in  security 


SOO  FOREIGN  EXCHANGE 

when  passing  through  their  hands.  From  the  standpoint  of 
those  banks  which  supply  bills  as  well  as  demand  them,  the 
brokers  provide  a  valuable  opportunity  to  exchange  those 
bills  which  do  not  suit  the  bankers'  needs  for  those  which  do, 
by  selling  the  former  and  buying  the  latter.  For  the  banks, 
discount  houses,  and  other  investors  who  do  not  supply  ac- 
ceptances to  the  market,  the  activities  of  the  brokers  save 
time  and  expense  by  bringing  to  their  counters  a  classified 
assortment  of  bills  from  which  to  fill  the  gaps  in  their  port- 
folios. 

Moreover,  aside  from  these  specific  services,  the  presence 
of  these  middlemen  in  large  numbers  conducting  their  trans- 
actions in  active  competition  with  each  other  provides  the 
machinery  through  which  a  uniform  and  stable  discount  rate 
can  be  worked  out  in  the  open  market.  By  keeping  in  touch 
with  the  available  sources  of  supply  and  demand,  receiving  a 
multitude  of  bids  and  ofi^ers  from  many  different  quarters, 
the  brokers,  by  striving  against  each  other  to  increase  their 
profit  and  expand  their  business,  adjust  the  rates  of  discount 
to  the  point  which  will  clear  the  market.  In  the  absence  of 
these  connecting  links  between  buyers  and  sellers,  many  dis- 
count rates  would  exist  simultaneously  applying  to  the  same 
type  of  instrument,  and  the  rates  would  be  much  more  sus- 
ceptible to  fluctuations  reflecting  the  bargaining  skill  of  buyer 
and  seller.  Under  such  conditions,  the  foreign  buyer  of  long 
dollar  bills  could  make  no  reliable  forecast  of  the  amount 
these  bills  would  add  to  his  New  York  balance  when  sold  in 
the  discount  market;  and  this  uncertainty  would  subject  the 
dollar  rates  of  exchange  in  foreign  cities  to  wide  fluctuations 
and  retard  the  use  of  dollar  exchange  in  international  com- 
merce. 

88.  The  Federal  Reserve  Bank  in  relation  to  the  discount 
market.  In  strict  theory,  the  Federal  Reserve  Bank  should 
act  solely  as  a  secondary  purchaser  of  acceptances  —  an 
agency  of  rediscount  to  which  other  banks  might  resort  in 
times  of  stringency.  This  was  the  function  of  the  Reserve 
Banks  contemplated  by  the  founders  of  the  system.  How- 
ever, the  Federal  Reserve  Act  made  provision  for  open  mar- 


THE  NEW  YORK  MARKET  391 

ket  operations  by  the  Reserve  Banks  in  the  following  words: 
**  Any  Federal  Reserve  Bank  may,  under  rules  and  regulations 
prescribed  by  the  Federal  Reserve  Board,  purchase  and  sell 
in  the  open  market,  at  home  or  abroad,  either  from  or  to  do- 
mestic or  foreign  banks,  firms,  corporations,  or  individuals, 
cable  transfers  and  bankers'  acceptances,  and  bills  of  exchange 
of  the  kinds  and  maturities  by  this  Act  made  eligible  for  re- 
discount, with  or  without  the  indorsement  of  a  member 
bank."  It  was  intended  that  these  open  market  operations 
should  be  incidental  to  the  chief  function  of  the  banks,  en- 
gaged in  to  enable  the  banks  to  exercise  a  greater  control  over 
the  market  when  it  was  deemed  advisable  and  to  employ 
their  funds  when  there  was  no  demand  for  rediscounts.  But 
since  the  founding  of  the  Reserve  System,  the  direct  dealings 
of  the  Reserve  Banks  in  acceptances  have  constituted  the 
largest  single  influence  in  the  discount  market.  This  situa- 
tion has  arisen  natm-ally  because  of  the  former  absence  of  a 
discount  market  and  the  ignorance  of  money-lenders  regard- 
ing the  excellencies  of  the  acceptance  as  an  investment  instru- 
ment. 

The  Reserve  Banks  conceived  it  to  be  their  first  duty  to 
develop  a  discount  market  able  to  stand  upon  its  own  feet. 
It  was  necessary  to  encourage  the  drawing  of  dollar  bills  both 
in  domestic  and  foreign  commerce,  and  to  develop  a  demand 
for  dollar  acceptances  by  convincing  the  money-lenders  of  the 
city  of  the  merits  of  this  new  kind  of  investment  instrument. 
In  pursuance  of  this  purpose,  the  Federal  Reserve  Banks  have 
carried  on  an  active  educational  campaign  throughout  the 
country  in  collaboration  with  commissions  and  associations 
formed  by  the  principal  credit  and  financial  institutions;  and 
to  give  a  material  impetus  to  the  movement,  they  have  held 
themselves  ready  to  take  off  the  market  all  acceptances  for 
which  no  other  purchasers  could  be  found.  At  the  outset, 
they  did  not  require  the  endorsement  of  bankers  upon  these 
acceptances,  but  bought  them  directly  from  the  first  sellers. 
In  this  way,  the  Reserve  Banks  assured  the  holders  of  accept- 
ances of  an  ever-present  market,  thus  encouraging  the  use  of 
dollar  credits  and  the  exercise  by  American  bankers  of  their 


S02 


FOREIGN  EXCHANGE 


new  powers  to  make  acceptances.  It  has  been  the  consistent 
elTort  of  the  Reserve  Banks,  Iiowever,  to  withdraw  from  the 
position  of  primary  purchasers  of  bills  by  fostering  the  growth 
of  the  market  to  the  point  where  its  funds  would  be  sufficient 
to  carry  the  volume  of  business.  When  this  point  is  reached, 
the  Reserve  Banks  will  hold  their  own  funds  in  reserve,  as 
does  the  Bank  of  England,  for  use  in  emergencies. 

The  following  table,  giving  the  total  of  bills  outstanding  at 
different  dates  and  the  percentage  of  these  bills  held  by  the 
Reserve  Banks,  is  signiJScant  from  many  points  of  view.  It 
discloses  the  growth  of  the  practice  of  making  acceptances, 
the  early  dependence  of  the  market  on  the  Reserve  Banks, 
and  the  gradual  broadening  and  strengthening  of  the  market 
to  a  degree  which  has  made  it  practically  independent. 

BlLI£  OWNED  BY  THE  FeDEEAL  ReSERVE  BaNKS  AT  VARIOUS  DaTES  * 


Date 

Owned  by  the 
Reserve  Bank 
of  New  York 

Ovmed  by  all 
Reserve  Banks 

Estimated 

amount 
outstanding 

Per  cent  of  all  tilU 

ovmed  by  Reserve 

Banks 

Dec.  31, 1916 

$  41,457,000 

$  127,497,000 

$  250,000,000 

51.0 

Dec.  31,  1917 

148,125,000 

275,366,000 

450,000,000 

61.2 

Dec.  31,  1918 

69,323,000 

303,373,000 

750,000,000 

40.5 

Dec.  31,  1919 

191,312,000 

583,212,000 

1,000,000,000 

58.5 

Dec.  31,  1920 

109,902,000 

255,702,000 

1,000,000,000 

25.6 

Mar.  25, 1921 

39,386,000 

123,056,000 

1,000,000,000 

12.3 

Note,  It  must  be  lemembered  that  these  figures  apply  to  all  acceptances  both  domestic  and 
foreign. 

Early  in  its  history,  the  Federal  Reserve  Board,  in  estab- 
lishing the  rates  of  discount  which  were  to  govern  the  open 
market  operations  of  the  Reserve  Banks,  discriminated  against 
the  promissory  note  m  favor  of  the  acceptance,  and  also 
against  the  trade  acceptance  in  favor  of  the  banker's  ac- 
ceptance. The  example  set  by  these  great  credit  institutions 
in  the  open  market  had  the  effect  of  forcing  the  other  banks 
into  line  with  their  policy  and  thus  to  establish,  as  the  stand- 

1  Taken  from  the  Bulletin  of  The  Federal  Reserve  Bank  of  New  York  for 
April,  1921, 


THE  NEW  YORK  MARKET  393 

ard  of  the  market,  preferential  rates  for  acceptances,  and 
especially  preferential  rates  for  the  banker's  acceptance. 
This  has  given  rise  to  a  schedule  of  discount  rates  in  the  mar- 
ket of  New  York  similar  to  that  of  London,  with  the  rate  for 
prime  bankers'  acceptances  at  the  base  of  the  schedule  and  the 
rates  for  other  bills  ranging  higher  according  to  differences 
in  security  and  term  of  life.  When  tlie  open  market  rate  of 
discount  is  mentioned  in  connection  with  the  bill  market, 
reference  is  had  to  the  basic  rate  of  the  system  —  the  rate 
applying  to  the  prime  acceptances  of  bankers  of  a  maturity 
which  qualifies  them  for  rediscount  with  the  Federal  Reserve 
Banks.  The  following  quotations  will  illustrate  the  spread 
between  the  different  classes  of  bills: 

Open  Market  Quotations  fob  June  10,  1921 

For  spot  delwery  ninety  days  sixty  days  thirty  days 

Prime  eligible  bills 6  ©5  7/8        5  7/8®  5  3/4        5  7/8@5  5/8 

For  delivery  vnthin  thirty  days 

Eligible  member  banks 6  l/8  bid 

Eligible  non-member  banks 6  l/4  bid 

Ineligible  bank  bills 6  7/8  bid 

These  rates  apply  only  to  bankers'  acceptances.  Prime 
eligible  bills  for  spot  delivery  may  be  translated  as  the  accept- 
ances of  first-class  bankers,  eligible  for  rediscount  at  the  Fed- 
eral Reserve  Bank,  and  ready  for  immediate  delivery  to 
the  buyer.  The  rates  for  these  prime  bills  vary,  as  may  be 
seen  by  examining  the  schedule,  as  between  maturities  of 
ninety,  sixty,  and  thirty  days;  the  higher  discounts  applying 
to  the  longer  maturities  because  of  the  added  risk  to  the  buyer 
involved  in  the  extended  period  before  redemption.  The  two 
rates  given  under  each  maturity  arc  the  "bid"  and  "asked" 
quotations,  or  the  buying  and  selling  rates,  respectively;  it 
will  be  seen,  by  comparing  these  two  quotations,  that  the 
spread  between  them  was,  on  the  day  in  question,  not  less 
than  1/8  per  cent.  The  second  part  of  the  schedule  refers  to 
the  rates  for  future  delivery,  based  upon  the  policy  of  the 
Federal  ReservcBank  of  pulilishing  a  "  forward  "  or  "arrival  " 
rate  of  discount  for  the  use  of  buyers  of  long  bills  in  foreign 


894  FOREIGN  EXCILVNGE 

markets.  Reference  will  be  made  to  this  practice  in  the  fol- 
lowing paragraph.  Reference  to  the  table  of  rates  for  future 
delivery  given  above  will  disclose  the  fact  that  the  market 
discriminates  between  bills  eligible  for  rediscount  with  the 
Reserve  Bank  and  those  ineligible  for  rediscount;  and  also 
discriminates  between  eligible  bills  on  the  basis  of  their  ac- 
ceptance by  member  and  non-member  banks  of  the  Federal 
Reserve  System.  Especially  sharp  is  the  discrimination  be- 
tween eligible  and  ineligible  bills;  in  the  table  given,  the  lowest 
rate  for  eligible  bills  for  future  delivery  is  6  1/8  per  cent,  while 
the  lowest  rate  for  ineligible  bills  is  6  7/8  per  cent,  a  differ- 
ence of  3/4  per  cent  in  favor  of  the  former.  This  difference 
between  the  buying  prices  for  the  two  classes  of  bills  is  an 
indication  of  the  power  of  the  rediscount  privilege  to  increase 
the  demand  of  investors. 

As  stated  above,  the  Federal  Reserve  Bank  has  adopted 
the  practice  of  publishing  a  "  forward"  or  "arrival"  rate  of 
discount  for  the  use  of  buyers  of  long  dollar  bills  in  foreign 
markets.  At  this  rate,  bills  which  arrive  in  the  market  within 
the  specified  time  limits  will  be  discounted.  Foreign  bankers, 
possessed  of  this  information,  are  able  to  ascertain  in  advance 
of  purchase  how  much  a  given  dollar  bill  will  increase  their 
New  York  balances  if  discounted  immediately  after  accept- 
ance. By  drawing  their  own  sight  drafts  for  this  amount, 
the  foreign  bankers  can  offset  their  purchases  of  long  dollar 
bills  without  delay,  and  from  the  ruling  dollar  sight  rate  can 
calculate  the  buying  price  for  the  long  bill.  The  publication 
of  a  forward  rate  of  discount  has,  therefore,  the  important 
effect  of  stabilizing  the  dollar  rates  of  exchange  in  foreign 
markets,  thus  reducing  the  risk  of  exchange  borne  by  export- 
ers who  finance  tlieir  transactions  with  long  dollar  bills,  and 
stimulating  the  use  of  dollar  exchange.  In  the  absence  of  a 
forward  rate  of  discount,  the  dollar  rates  in  foreign  markets 
would,  of  necessity,  contain  a  large  element  of  insurance  to 
protect  the  banker  against  possible  adverse  fluctuations  in 
the  New  York  discount  rates  while  the  bills  were  in  transit. 
The  commercial  banks  of  New  York  which  have  formed  cor- 
respondent agreements  with  foreign  bankers,  or  have  estab- 


THE  NEW  YORK  MARKET  395 

Hshed  their  own  branches  abroad,  send  periodic  advices  to 
their  associates  in  the  foreign  centers  upon  this  subject  of  the 
market  rates  of  discount  in  the  near  future. 

So  far  we  have  been  speaking  of  the  open  market  operations 
of  the  Federal  Reserve  Bank,  and  of  the  effect  of  these  opera- 
tions upon  the  market.  But  the  original  purpose  of  the  Fed- 
eral Reserve  System  was  to  establish  a  group  of  institutions 
whose  primary  function  should  be  that  of  rediscount.  That 
the  open  market  operations  of  the  Reserve  Banks  have 
bulked  so  large  in  the  total  business  of  the  market  has  been 
due  to  the  market's  lack  of  an  adequate  supply  of  loan  funds 
drawn  from  other  sources,  a  condition  which,  it  is  hoped,  will 
disappear  in  time.  The  provisions  of  the  Federal  Reserve  Act 
with  respect  to  the  eligibility  of  bills  for  discount  may  be 
summarized  as  follows:  (a)  the  bills  must  be  the  acceptances 
of  member  banks  of  the  System,  or  of  non-member  banks 
which  have  fulfilled  certain  requirements  of  the  Federal  Re- 
serve Board;  {h)  they  must  be  "commercial"  bills, ^  or  bills 
secured  by  Government  bonds  or  notes;  (c)  they  must  have  a 
maturity  not  longer  than  ninety  days;  acceptances  with  a 
tenor  of  more  than  ninety  days,  if  eligible  in  other  respects, 
become  rediscountable  ninety  days  before  their  maturity. 
Evidence  of  eligibility  must  appear  on  the  face  of  all  redis- 
counted  bills  in  the  form  of  a  rubber  stamp  endorsement.^ 

The  distinctive  and  most  important  function  of  a  redis- 
counting  agency  is  to  afford  the  credit  institutions  of  the 
country  a  method  of  relief  from  an  over-extended  position 
during  periods  of  credit  stringency,  but  to  do  this  in  a  manner 
that  will  check  the  expansion  of  credit  and  relieve  the  stress. 
This  double  purpose  can  be  achieved  only  on  one  condition: 
namely,  that  the  rediscount  rate  is  higher  than  the  rate  of 
discount  in  the  market  at  the  time  when  rediscounting  begins. 
The  banks  which  resort  to  rediscounting  must  do  so  at  a  loss 
of  profit  to  themselves,  else  there  would  be  no  incentive  for 

^  See  definition  on  page  377. 

2  The  Ileserve  Banks  rediscount  promissory  notes,  in  addition  to  bills  of 
exchange,  and  also  make  fifteen-day  collateral  loans  to  their  members  based 
on  bills,  notes,  and  Government  bonds. 


896  FOREIGN  EXCHANGE 

them  to  raise  their  rates  to  their  customers,  and  no  pressure 
upon  the  market  to  curtail  the  expansion  of  credit.  When  the 
rediscount  rate  is  lower  than  the  market  rate,  the  banks  may 
recover  the  funds  they  extend  in  the  piu-chase  of  acceptances 
and  to  other  borrowers  at  a  cost  lower  than  the  charge  they 
make  their  own  customers  for  the  use  of  these  funds.  This 
situation  merely  encourages  the  banks  to  pass  their  paper 
over  to  the  rediscounting  agency  and  continue  lending;  the 
assets  of  the  Reserve  Banks  under  such  conditions  simply 
form  an  additional  reservoir  of  credit  to  be  absorbed  in  the 
market,  and  credit  expansion  is  allowed  to  run  to  greater 
extremes  than  if  the  banks  were  compelled  to  rely  upon  their 
cw^n  resources.  Obviously,  this  defeats  the  purpose  of  the 
rediscounting  agency.  The  cardinal  principle  that  the  redis- 
count rate  must  be  higher  than  the  market  rate  has  been  care- 
fully observed  by  the  central  banks  of  Europe.  The  Bank  of 
England,  for  example,  has  never  allowed  its  rate  to  remain 
lower  than  the  market  rate  of  discount  during  the  last  half- 
century;  and  a  similar  policy  has  been  followed  by  the  Bank 
of  France,  the  Bank  of  Germany,  and  the  other  central  banks 
of  Europe.  In  these  countries  (we  deal,  of  course,  with  condi- 
tions prevailing  before  the  Great  War)  resort  to  rediscounting 
is  had  only  at  a  sacrifice  to  the  borrower;  during  quiet  periods, 
when  the  banks  can  carry  the  business  of  the  market  without 
rediscounting,  the  rediscount  rate  stands,  nevertheless,  above 
the  market  rate  and  the  central  banks  are  content  to  allow 
their  funds  to  remain  comparatively  idle  until  occasion  arises 
for  their  use. 

The  abnormal  conditions  which  have  prevailed,  practically 
from  the  beginnings  of  the  Federal  Reserve  System,  have 
prevented  the  Reserve  Banks  from  conforming  to  this  car- 
dinal principle  of  the  rediscounting  agency.  Before  the  dis- 
count market  was  well  established,  the  United  States  was  at 
war;  and  during  the  war  period,  the  rediscounting  policy  of 
the  Reserve  Banks  was  determined  by  political  exigency  and 
not  by  considerations  of  business  prudence.  The  most  seri- 
ous business  of  the  Reserve  Banks  was  that  of  aiding  the 
Government  in  the  sale  of  war  bonds.    The  banks  and  credit 


THE  NEW  YORK  MARKET  897 

institutions  of  the  country  were  encouraged  to  extend  credit 
to  their  depositors,  at  rates  of  interest  no  higher  than  the  bond 
rate,  for  the  purpose  of  buying  these  bonds;  and  the  Federal 
Reserve  Board,  to  encourage  this  poUcy,  was  compelled  to  fix 
the  rediscount  rate  with  reference  to  the  bond  rate  to  the  end 
that  the  banks,  which  were  forced  to  rediscount  heavily  in 
order  to  carry  the  burden  of  war  financing,  might  do  so  with- 
out loss  to  themselves.  The  result  of  this  policy  was  to  allow 
credit  expansion  to  proceed  unchecked  to  a  point  far  beyond 
normally  safe  limits.  During  the  severe  crisis  of  1920,  the 
rediscount  rates  were  advanced,  but  the  bankers'  rates  of 
discount  for  most  classes  of  commercial  paper  were  also  ad- 
vanced to  a  position  above  the  rediscount  rates.  The  record 
of  the  Federal  Reserve  Banks,  therefore,  cannot  be  taken  as 
indicative  of  the  relationship  which  they  will  hold  toward  the 
market,  and  the  power  they  will  exert  over  the  operations  of 
the  market,  when  they  have  begun  truly  to  function  as  agen- 
cies of  rediscount. 

The  interrelation  of  the  Reserve  Bank  and  the  open  market 
for  acceptances  in  New  York  cannot  be  compared  with  that 
of  the  Bank  of  England  to  the  discount  market  of  London. 
The  Bank  of  England  does  not  rediscount  commercial  loans 
and  advances  made  by  the  London  banks;  it  rediscounts  only 
bills  of  exchange.  It  has  been  estimated  that  of  the  assets  of 
the  London  banks  under  normal  conditions,  about  twenty- 
five  per  cent  consists  of  bills.  ^  The  rediscounting  policy  of 
the  Bank  of  England  is  brought  to  bear  upon  this  portion  of 
the  banks'  assets,  only;  hence,  the  discount  market  for  ac- 
ceptances is  immediately  influenced  by  this  rediscounting 
policy  in  times  of  stringency.  All  interest  rates  respond 
quickly  to  changes  in  the  rates  for  bankers'  acceptances, 
since  it  is  through  the  agency  of  rediscounted  acceptances,  if 
at  all,  that  the  banks  will  find  relief  from  a  condition  of 
strained  credit.^    The  discount  market,  therefore,  forms  the 

1  See  The  Chase  Economic  Bulletin  for  July  20,  1921,  p.  9. 

2  The  London  banks  do  not  rediscount  directly,  but  avail  themselves  of 
the  opportunity  to  reduce  their  holding  of  bills  through  the  medium  of  the 
exchange  brokers.    See  the  discussioa  on  pages  336  f. 


S98 


FOREIGN  EXCHANGE 


channel  through  which  the  Bank  of  England  brings  its  influ- 
ence to  bear  upon  the  credit  structure  of  London.  The  Offi- 
cial Rate  of  the  Bank  is  set  with  reference  to  the  basic  dis- 
count rate  of  the  open  market  for  bills  of  exchange. 

Discount  Rates  of  the  Federal  Reserve  Banks  in  Effect 
June  10,  1921 


Federal  Ruene  Bank 

Discounted  bills  maturing  within 

ninety  days  {including  member 

banks  fifteen-day  collateral  notes) 

secured  by 

H 

0-T3 

"el 

II 

2  w"a 

<*f 

Treasury 
certificates  of 
indebtedness 

Liberty 

Bonds  and 

Victory 

Notes 

Otherwise 

secured 

and 

unsecured 

3  B.O 

Boston 

6 
6 

*6 
6 
6 
6 
6 
6 
6 

*6 
6 
6 

6 
6 

5h 

6 

6 

6 

6 

6 

6 

6 

6 

6 

6 

6i 

6 

6 

6 

6 

6i 

6 

6^ 

6 

61 

6 

6 
6 
6 
6 
6 
6 

5^ 

6 

5^ 

6 

6 

6^ 

6 

6 

6 

6 

6i 

6 

6^ 

6 

6§ 

6 

6 

New  York 

Philadelphia 

Cleveland 

Richmond 

Atlanta 

6^ 

6 

6 

6 

6 

Chicago 

St.  Louis 

Minneapolis 

Kansas  City 

Dallas 

6i 

6 

61 

6 

6^ 

San  Francisco .  . . 

6i 

*  Discount  rate  corresponds  with  interest  rate  borne  by  certificates  pledged  as  collateral. 

In  New  York,  on  the  other  hand,  acceptances  not  only  form 
a  much  smaller  percentage  of  the  assets  of  the  banks,  but  they 
also  form  but  one  of  a  number  of  contacts  between  the  central 
agency  of  rediscount  and  the  banks  of  the  city.  It  will  be 
seen,  by  examining  the  table  of  rediscount  rates  given  on 
this  page,  that  the  Reserve  Banks  rediscount  not  only  bills  of 
exchange,  but  other  types  of  commercial  paper  as  well.  At 
present,  trade  and  bankers'  acceptances  supply  a  minor  share 
of  the  rediscounts.  To  base  the  rediscount  rates  of  the  Re- 
serve Banks  upon  the  open  market  rate  for  acceptances  would 
not,  under  these  conditions,  directly  and  immediately  aflfect 


THE  NEW  YORK  MARKET  S99 

the  credit  policy  of  the  commercial  banks,  as  a  similar  prac- 
tice of  the  Bank  of  England  affects  the  credit  policy  of  the 
banks  of  London.  Reference  to  this  table  will  show  that  the 
rediscount  rate  for  bankers'  acceptances  in  New  York  stood, 
on  June  10,  1921,  at  6  per  cent;  on  the  same  day,  the  open 
market  rate  for  this  type  of  acceptance  varied  from  6  to  5  5/8 
per  cent  according  to  maturity.  The  rediscount  rate,  there- 
fore, was,  on  the  whole,  higher  than  the  market  rate  for  bank- 
ers' acceptances;  but  the  banks  were  not  compelled  to  redis- 
count acceptances  in  order  to  obtain  advances  from  the  Fed- 
eral Reserve  Banks,  since  they  could  borrow  on  their  fifteen- 
day  paper.  The  rate  on  this  date  for  advances  to  the  banks 
on  their  fifteen-day  paper  secured  by  other  than  Government 
obhgations  was  6  1/2  per  cent.  But  the  rate  prevailing  in  the 
market  for  commercial  loans  was  a  full  half  per  cent  higher  at 
this  time;  hence,  the  banks  could  extend  loans  to  their  cus- 
tomers under  the  ordinary  "line  of  credit"  policy,  and  make 
an  additional  profit  by  borrowing  from  the  Reserve  Banks 
the  money  thus  loaned.  To  make  their  rediscount  rate  effec- 
tive at  a  time  when  the  Reserve  Banks  desire  to  check  the 
credit  expansion  of  the  country  would  require  a  raising  of  each 
of  the  rediscount  rates  to  a  point  higher  than  the  interest  rate 
applying  to  the  particular  kind  of  paper  upon  which  the  redis- 
count was  based.  In  this  respect,  the  New  York  market 
contrasts  strikingly  with  the  London  market  where  single 
rediscount  rate,  applying  only  to  bankers'  acceptances,  is 
effective  to  control  the  entire  schedule  of  interest  rates  in  the 
money  market.  What  the  future  will  bring  forth  with  regard 
to  the  relationship  of  the  Reserve  Banks  to  the  discount  mar- 
ket depends,  in  large  part,  upon  the  development  of  the  dollar 
acceptances  and  the  increased  importance  of  acceptances 
among  the  assets  of  the  banks. 

International  relationships  have  been  so  abnormal  since 
the  founding  of  the  Federal  Reserve  System  that  it  is  impos- 
sible from  the  record  to  predict  with  confidence  whether  the 
Reserve  Bank  of  New  York  will  ever  hold  a  position  of  inter- 
national importance  similar  to  that  of  the  Bank  of  England. 
Certain  possible  lines  of  development  may,  however,   be 


400  FOREIGN  EXCHANGE 

marked  out.  If  the  discount  market  continues  to  develop, 
and  if  the  Reserve  Banks  consistently  follow  the  policy  of 
holding  their  rediscount  rates  above  the  market  rates,  it 
should  be  possible  to  equalize  the  rates  of  interest  between 
the  New  York  market  and  the  markets  of  other  countries; 
and  possible,  also,  to  exert  some  degree  of  control  over  the 
flow  of  gold  to  and  from  New  York.  In  the  past.  New  York 
has  been  more  or  less  isolated;  it  has  never  been  able  to  exert 
the  far-reaching  influence  over  the  credit  conditions  of  the 
world  as  has  the  market  of  London.  But  the  broadening  of 
the  New  York  market  and  the  development  of  stable  rates  of 
discount  there  should  bring  this  isolation  to  a  close.  A  stable 
discount  market  will  encourage  foreign  bankers  to  buy  dollar 
acceptances  when  the  discount  rates  in  New  York  are  rela- 
tively high;  and  to  sell  these  acceptances  in  New  York  when 
the  interest  rates  there  are  relatively  low.  By  buying  dollar 
acceptances  when  the  New  York  rates  are  higher  than  the 
rates  in  foreign  markets,  foreign  bankers  will  diminish  the 
number  of  bills  offered  on  the  discount  market  of  New  York, 
and,  at  the  same  time,  absorb  a  part  of  the  loan  funds  in  their 
own  markets.  The  result  of  this  practice  will  be  to  bring  the 
New  York  rates  of  interest  down  and  the  foreign  rates  up, 
until  they  tend  to  equal  each  other.  The  selling  of  dollar 
acceptances  in  New  York  when  the  rates  of  interest  are  lower 
than  the  foreign  rates  will  tend  to  reach  the  same  end  by  a 
reverse  process.  This  practice  will  increase  the  supply  of  ac- 
ceptances in  New  York  and  release  a  part  of  the  loan  funds 
abroad;  in  other  words,  it  will  increase  the  demand  for  funds 
where  the  rate  of  interest  is  low  and  the  supply  of  funds  where 
the  rate  is  high,  which,  obviously,  will  tend  to  equalize  the 
rates.  These  developments  lie  in  the  future  and  are  condi- 
tioned upon  the  growth  of  the  discount  market. 

Closely  related  to  this  reaction  of  the  New  York  rates  of 
discount  upon  those  of  other  markets  is  the  possibility,  granted 
an  adequate  development  of  the  bill  market  in  New  York,  of 
controlling  the  flow  of  gold  to  and  from  the  United  States  by 
methods  similar  to  those  used  by  the  Bank  of  England.  The 
lack  of  a  central  rediscounting  agency,  and  the  absence  of  an 


THE  NEW  YORK  MARKET  401 

open  bill  market,  have  made  it  impossible  in  the  past  for  New 
York  to  exercise  an  intelligent  control  over  these  gold  move- 
ments; but  in  the  present  mechanism  of  the  market  exists 
machinery  which  may  make  this  possible  in  the  future.  To 
repeat  the  gist  of  an  earlier  explanation,  gold  flows  out  of  a 
country  when  that  country's  bills  are  quoted  in  foreign  mar- 
kets at  the  specie  importing  point;  and  this  will  come  to  pass 
when  there  is  an  excess  supply  of  these  bills  offered  for  sale 
abroad.  Under  these  circumstances,  for  a  central  bank  to 
influence  the  foreign  dollar  rates  so  that  the  flow  of  gold  from 
New  York  will  be  checked  requires  two  essentials:  there  must 
be  an  active  open  market  for  bills  of  exchange  in  New  York, 
and  the  rates  in  this  market  must  be  under  the  control  of  the 
rediscounting  agency.  In  times  past  New  York  has  had 
neither  of  these  essentials;  in  the  future,  provided  the  open 
market  develops  sufficient  strength,  the  Federal  Reserve 
Bank  may  enjoy  power  to  control  gold  movements. 

When  a  central  institution  advances  the  rediscount  rate 
and  forces  the  market  rates  to  rise,  the  rates  of  exchange  in 
foreign  markets  are  affected  through  four  channels:  (a)  the 
higher  discount  rates  will  encourage  the  holding  for  invest- 
ment of  long  bills  drawn  on  that  market,  thus  reducing  the 
amount  of  sight  drafts  offered  abroad;  (b)  it  will  discourage 
the  drawing  of  finance  bills  on  that  market,  thus  preventing 
the  issue  of  sight  drafts  against  them  as  cover;  (c)  it  will  en- 
courage the  closing  out  of  existing  loans  contracted  by  foreign 
bankers  in  that  market,  which  will  increase  the  demand  for 
sight  drafts  aVjroad;  (d)  it  will  encourage  bankers  in  that 
market  to  draw  finance  bills  on  foreign  bankers  which  will 
increase  the  demand  for  sight  drafts  abroad.^  Two  of  these 
forces  diminish  the  supply  of  sight  drafts  drawn  by  foreign 
bankers  on  the  market  where  the  rates  of  discount  are  rising; 
two  of  them  increase  the  demand  for  these  sight  drafts;  the 
combined  effect  being  to  raise  the  sight  rate,  whose  decline  to 
the  specie  point  was  the  cause  of  the  loss  of  gold  by  the  market 
in  question.  However,  before  the  Federal  Reserve  Banks  can 
exert  so  significant  an  influence  over  the  conditions  in  foreign 
*  For  fuller  exposition  of  these  forces  see  pages  343  f. 


405  FOREIGN  EXCHANGE 

markets,  the  discount  market  of  New  York  must  have  devel- 
oped to  such  a  point  that  foreign  bankers  habitually  carry 
investments  in  long  dollar  bills,  and  these  dollar  bills  arise  in  all 
parts  of  the  world  as  financing  agencies  in  the  trade,  not  only 
of  the  United  States,  but  of  other  countries  as  well.  In  other 
words,  the  long  dollar  bill  must  have  become  what  the  sterling 
bill  has  long  been  —  a  standard  financing  instrument  of  inter- 
national commerce;  and  the  discount  market  of  New  York 
must  have  become  the  rival  of  that  of  London  as  a  center  of 
the  credit  operations  of  the  world.  Sufficient  time  has  not 
elapsed  since  the  improvement  of  the  credit  machinery  of  New 
York  to  permit  the  dollar  bill  and  the  discount  market  to 
attain  this  preeminence. 

89.  Dollar  exchange.  At  the  beginning  of  this  chapter, 
certain  handicaps  were  descril)ed  which,  until  recent  years, 
prevented  dollar  exchange  from  becoming  a  financing  agency 
of  large  importance  in  international  commerce.  We  have 
now  examined  the  changes  which  have  occurred  since  the 
passage  of  the  Federal  Reserve  Act;  so  far  as  they  inhered  in 
a  lack  of  adequate  machinery  in  the  New  York  market,  the 
handicaps  to  the  growth  of  dollar  exchange  have  been  re- 
moved. In  concluding  this  subject,  we  may  with  profit  revert 
to  the  question  of  dollar  exchange  with  the  purpose  of  study- 
ing its  development  since  these  changes,  and  of  forecasting  its 
probable  future. 

The  use  of  dollar  exchange  made  possible  by  the  legaliza- 
tion of  bankers'  acceptances  and  the  establishment  of  a  dis- 
count market  in  New  York,  and  encouraged  by  the  spread  of 
American  branch  banks  abroad,  was  greatly  stimulated  by 
the  Great  War.  In  the  first  place,  the  United  States  soon 
became  for  neutral  nations  the  only  available  market  in  which 
to  buy  many  of  the  goods  formerly  supplied  by  England, 
Germany,  and  France,  and  for  the  belligerent  countries  the 
sole  source  of  supply  for  many  indispensable  commodities. 
This  insistent  demand  for  the  products  of  the  United  States 
has  continued  with  little  diminution  down  to  the  present 
time;  it  has  made  possible  the  imposition  of  stringent  terms  of 
payment,  either  cash  against  documents  in  New  York,  or  the 


THE  NEW  YORK  MARKET  403 

establishment  of  a  dollar  credit  in  favor  of  the  exporter.  These 
terms  of  payment  require  the  use  of  dollar  exchange.  In  the 
second  place,  the  Government  and  people  of  the  United  States 
have  made  immense  loans  in  dollars  to  many  foreign  nations, 
and  especially  to  England  and  France.  These  vast  dollar 
credits  have  been  used  to  finance  the  trade  of  the  borrowing 
nations  not  only  with  the  United  States,  but  with  other  coun- 
tries as  well,  supplanting  for  the  latter  purpose  the  sterling 
credit.  Finally,  a  number  of  the  larger  American  banks  have 
made  a  concerted  effort  to  popularize  the  dollar  credit  both  at 
home  and  abroad,  being  aided  in  this  effort  in  foreign  coun- 
tries by  the  reliance  of  the  world  upon  the  United  States  for 
goods  and  credit.  The  results  of  these  different  forces  have 
been  very  marked.  In  many  markets  —  among  them  Brazil, 
Argentina,  Greece,  India  —  dollar  exchange  is  now  quoted  for 
the  first  time;  in  Japan  and  China,  where  payment  was  for- 
merly made  in  sterling,  dollars  have  become  the  most  easily 
negotiated  of  all  forms  of  exchange;  direct  exchange  has  begun 
between  the  United  States  and  South  Africa  and  other  parts 
of  the  British  Empire.  This  evidence  has  been  hailed,  though 
somewhat  prematurely,  by  American  observers  as  evidence 
that  New  York  has  already  supplanted  London  as  the  center 
of  the  world's  business  in  foreign  exchange. 

There  are  some  factors  in  the  present  situation  which  will 
tend  to  perpetuate  the  dominance  of  New  York,  or,  at  least, 
to  assure  that  city  a  permanent  position  in  international  fi- 
nance of  greater  importance  than  she  has  enjoyed  in  the  past. 
The  creditor  position  of  the  United  States,  the  rise  of  our 
country  to  prominence  as  a  carrier  nation,  the  rapid  increase 
in  our  foreign  commerce,  the  improvement  of  our  banking 
structure  and  the  spread  of  American  banks  throughout  the 
world,  v/ill  cooperate  to  increase  the  usefulness  of  dollar  bills 
and  to  improve  the  foreign  market  for  these  bills.  Over 
against  these  forces,  in  any  attempt  to  measure  the  compara- 
tive strength  of  London  and  New  York,  must  be  set  exactly 
the  same  forces  working  with  at  least  equal  power  in  favor  of 
London;  and,  in  addition,  the  prestige  and  good-will  which 
London  has  built  up  through  a  century  and  a  half  of  continu- 


404  FOREIGN  EXCHANGE 

oiis  and  succcs5?ful  operation.  However,  this  method  of  fore- 
casting the  future  of  the  two  markets  is  of  little  significance; 
in  the  final  analysis,  the  decision  as  to  the  kind  of  exchange  to 
be  used  for  financing  international  trade  will  rest  with  the 
merchants  who  must  pay  the  financing  costs.  That  type  of 
bill  will  be  used  which  is  most  easily  negotiated  and  for  the 
highest  price  by  the  drawer,  and  this  matter  will  be  decided 
by  the  efiiciency  of  the  discount  market  in  which  the  bills  are 
offered  for  sale  by  their  buyers.  Tendencies  which  increase 
the  foreign  market  for  demand  drafts  drawn  in  dollars  will 
lend  support  to  the  use  of  long  dollar  bills.  But  if  New  York 
is  to  become  the  center  of  the  world's  foreign  exchange  mar- 
kets, and  the  long  dollar  bills  the  typical  financing  instru- 
ments in  international  commerce,  the  discount  market  of  New 
York  must  first  develop  to  a  point  where  it  is  able  to  discharge 
with  ease  all  calls  made  upon  it  to  advance  funds  for  the  pur- 
chase of  acceptances,  and  the  rates  in  that  market  must  be  as 
low  as,  or  lower  than,  those  offered  by  London  and  other  cen- 
ters. Until  the  present  time  it  cannot  be  said  that  either  of 
these  conditions  has  been  fulfilled. 


INDEX 


Acceptance;  defined  6;  presentment 
for  5;  as  an  investment  security  8; 
as  collateral  for  call  loans  330;  as  a 
bank  asset  370,  397. 

Acceptance  account  216,  319. 

Acceptance  agreement;  between  two 
banks  215,  319;  between  exporter 
and  bank  245. 

Acceptance,  banker's;  of  commercial 
bills  92;  of  bankers'  bills  144;  as  a 
loan  of  funds  148;  under  letter  of 
credit  206;  against  exporters'  bills 
245;  formerly  forbidden  in  United 
States  366;  under  the  Federal  Re- 
serve Act  374;  discount  raJd  apply- 
ing to  in  open  market  331,  393. 

Acceptance  charges  of  London  banks 
217. 

Acceptance  credit;  in  favor  of  bank 
216;  in  favor  of  exporter  245. 

Advance  payment  by  importer  262. 

Arbitrage;  two  point  99;  based  on 
non-equivalence  of  cable  rates  98; 
stabilizing  effect  on  rates  102. 

Arbitrage  in  securities  27. 

Arrival  or  forward  rate  of  discount 
394. 

Australasian  bills.  Colonial  Clause 
borne  by  193. 

Authority  to  draw  253. 

Authority  to  purchase  248. 

Balance,  foreign ;  affected  by  dealings 
in  bills  18;  relation  to  rates  of  ex- 
change 60;  of  New  York  banks  in 
London  316;  rules  governing  318. 

Balance  of  payment;  relation  to  rate 
fluctuations  109 ;  relation  to  invest- 
ment 304. 

Bank  credit;  various  forms  used  in 
foreign  trade  340;  relation  to  de- 
mand and  supply  of  bills  257. 

Bank  of  England ;  buying  and  selling 
prices  for  gold  68,  70;  relation  to 
open  market  334;  relief  of  credit 


stringency  336;  control  of  discount 
rates  338;  control  of  gold  move- 
ments 343;  relations  with  Federal 
Reserve  Bank  379. 

Bank  of  France;  control  of  gold  ship- 
ments 358. 

Bank  price  for  gold;  England  68,  70; 
France  358. 

Bank  rate  of  rediscount;  London  338; 
New  York  395. 

Banker's  demand  draft;  commercial 
use  of  130;  order  for  135;  specimen 
of  136;  supply  and  demand  of  con- 
trol rate  of  exchange  137 ;  of  inland 
bankers  141. 

Banker's  long  bills;  credit  element 
involved  in  144;  specimen  of  14G; 
finance  bills  148;  drawn  against 
payment  bills  149. 

Banker's  buying  rate  for  commercial 
bills  93. 

Banker's  commission  borne  by  im- 
porter 276. 

Banker's  selling  rates;  cables  87;  long 
bills  89. 

Banks,  relation  of  to  discount  market 
327. 

Barter;  results  from  use  of  bills  of  ex- 
change 35. 

Bill  of  exchange;  defined  3;  classified 
3;  domestic  use  of  9;  foreign  bill  12. 

Bill-broker;  in  London  328;  in  New 
York  387;  relation  to  banks  330; 
commission  charges  of  389 ;  services 
of  389. 

Bill  of  lading;  defined  163;  classified 
164. 

Branch  banks;  in  London  314;  of 
American  banks  371;  of  Federal 
Reserve  Bank  379;  importance  of 
371. 

Cable  exchange;  commercial  use  of 

131;  order  for  134. 
Cable  rate;  interest  element  in  86; 


406 


INDEX 


calculation  of  from  sight  rate  86; 
sprciid  of  8ii;  parity  of  with  sight 
95. 

C.A.F.  273. 

Call  loans  based  on  acceptances;  Lon- 
don 330;  New  York  388. 

Cash  against  documents  262. 

Cash  on  delivery  sales;  how  effected 
through  bill  of  exchange  365. 

Cash  with  order  362. 

Check,  traveler's  238. 

Chinese  currency  50. 

C.I.F.  274. 

Clean  biUs  189. 

Collection  bills  91. 

Collection  function  performed  by  bills 
of  exchange  286. 

Colonial  banks  in  London  314. 

Colonial  clause  193. 

Commerce  affected  by  rates  of  ex- 
change 111. 

Commercial  bills;  defined  159;  classi- 
fied 160;  long  bills  160;  documen- 
tary 162;  acceptance  bills  177;  pay- 
ment bills  178;  clean  189;  sight  190; 
bearing  colonial  clause  193;  calling 
for  return  draft  196 ;  bearing  inter- 
est clause  202. 

Commercial  letter  of  credit;  dollar 
credit  206;  application  for  dollar 
credit  207;  contract  for  same  208; 
specimen  of  same  212;  illustration 
of  use  208;  sterling  credit  215; 
banking  relations  created  by  same 
215;  contract  for  218;  specimen  of 
223;  confirmation  of  224;  burden 
of  advance  in  use  of  letter  of  credit 
227 ;  superiorities  of  letter  of  credit 
230. 

Commission  charges  of  correspondent 
banks  321. 

Compensating  purchase  and  sale  19. 

Complete  sets  of  bills  175. 

Confirmed  credit  224;  242. 

Contract;  for  authority  to  purchase 
246;  for  letter  of  credit  208. 

Control  of  gold  shipments;  by  raising 
discount  rates  313;  by  other  means 
353. 

Correspondent  relations  between 
banks  314. 

Costs  of  gold  shipments  66. 


Costs  of  transportation;  how  placed 
on  importer  270. 

Date  bills;  how  used  for  investment 
299. 

Days  of  grace  5. 

Deferred  payment  by  importer  268. 

Delegation,  letter  of  266. 

Demand  and  supply;  sources  of  22; 
control  exchange  rates  60,  137. 

Deposit  allowance  rate  319. 

Depreciation  of  paper  money  52. 

Direct  exchange  368. 

Discount;  relation  to  rate  of  exchange 
89. 

Discount  houses;  London  333;  New 
York  386. 

Discount  market.  See  London;  New 
York. 

Discount  rate;  relation  to  long  ex- 
change rate  88,  347;  relation  to 
finance  bills  149;  how  established 
in  market  331;  how  used  to  influ- 
ence gold  movements  343;  relation 
to  investment  in  bills  of  exchange 
297,  347. 

Dishonor  6. 

Documents;  why  attached  to  bills 
162;  description  of  163. 

Documentary  acceptance  bill  176. 

Documentary  payment  bill;  market- 
ability of  94;  not  discountable  326; 
as  cover  for  banker's  bill  148;  as 
cover  for  future  contract  106;  re- 
lease of  documents  before  payment 
180. 

Dollar  exchange  402. 

Dollar  letter  of  credit  206. 

Dollar  loan  151. 

Dollar  return  draft  196,  199. 

Domestic  bill  9. 

Drawee  3. 

Drawer  3. 

Duplicate  bills  175;  uses  of^in  case  of 
investment  298. 

Economic   functions  of  bills   of   ex- 
change 285. 
Eligibility  of  bills  for  rediscount  377. 
Embargo  on  gold  122. 
Endorsement.    See  Indorsement. 
England;  monetary  system  45;  par 


INDEX 


407 


with  47;  foreign  investment  of  25. 
iSee  Bank  of  England;  London. 

Exchange;  as  used  in  colonial  clause 
194. 

Exchange  rates.  See  Ratesof  Exchange. 

Exports;  a  source  of  supply  of  bills  of 
exchange  22;  how  affected  by  ex- 
change rates  111;  how  affected  by 
depreciated  currency  113;  by  silver 
exchanges  117. 

Extension  of  acceptance  or  payment 
170, 

F.A.S.  272. 

Federal  Reserve  Act  273. 

Federal  Reserve  Banks;  number  and 
location  376;  rediscount  powers 
377;  foreign  connections  378;  open 
market  operations  390;  rediscount 
operations  395. 

Fiduciary  money  43. 

Finance,  definition  290. 

Finance  bills;  definition  148;  when 
drawn  149 ;  nature  of  credit  advance 
secured  by  150;  dollar  loan  151; 
sterling  loan  153. 

Financing  cost,  how  placed  on  im- 
porter 275. 

Financing  function  of  bills  of  ex- 
change 289. 

Fluctuating  pars;  silver  exchanges  49; 
paper  exchanges  55. 

F.O.B.;  definition  271;  calculation 
275. 

Foreign  balance.    See  Balance. 

Foreign  investments;  relation  to  de- 
mand and  supply  of  bills  242 ;  effect 
on  commerce  306. 

France;  monetary  system  45;  par 
with  47.   See  Bank  of  France. 

Franco  domicile  275. 

Freight  payments,  relation  of  to  ex- 
change market  24. 

Futures;  speculative  use  of  104;  hedg- 
ing by  means  of  283. 

Germany ;  par  with  47. 

Gold;   buying  and   selling  prices  in 

London  08,  70;  in  Paris  358. 
Gold  embargo;  effect  of  on  exchange 

market  122. 
Gold  exchange  standard  72;  Philip- 


pine exchange  75;  Indian  exchange 
76;  Straits  Settlements  76. 

Gold  export;  basic  cause  of  111;  rea- 
sons for  opposing  122;  international 
effect  of  125. 

Gold  points  64;  determination  of  66. 
tSee  Specie  Points. 

Gold,  price  of;  market  and  mint  prices 
44;  price  in  London  68,  70;  in  Paris 
358. 

Gold  shipments;  interest  cost  of  66, 
69;  made  by  specialists  only  71; 
economic  cause  of  111;  effect  on 
price  levels  125;  controlled  by  dis- 
count rate  343;  other  expedients 
for  controlling  353. 

Great  Britain.  See  England;  Bank  of 
England;  London. 

Hedging  283. 

Hypothecation;  definition  165;  letter 
of  168. 

Importer's  risk  under  letter  of  credit 
232. 

Imports  stimulated  by  low  exchange 
rates  111. 

Indian  exchange  76. 

Indorsement;  of  bills  of  lading  164; 
of  investment  bills  299;  by  London 
brokers  333 ;  by  New  York  brokers 
389. 

Inland  bankers,  bills  drawn  by  141. 

Insurance  certificate  165. 

Interest  cost ;  how  placed  on  importer 
276. 

Interest  cost  in  gold  shipments  66,  69, 

Interest  clause  on  commercial  bills 
202. 

Interest  earned  by  foreign  balance 
318. 

Interest-free  advances  to  induce  gold 
imports  355. 

Interest  payments;  international,  re- 
lation to  exchange  market  29. 

Investments;  relation  to  exchange 
market  24;  investment  in  hills  of 
exchange  295;  how  affected  by  for- 
eign discount  market  297;  use  of 
date  bills  for  this  purpose  300;  long 
terra,  effect  on  exchange  market 
302;  relation  to  commerce  304. 


408 


INDEX 


Investment  trusts  311. 
Irrevocable  credit  221,  244. 

Letter  of  credit;  definition  205;  dollar 
letter  200;  application  for  same  207; 
uses  of  208;  sterling  letter  215;  con- 
firmation of  222;  commercial  uses 
225;  credit  relations  created  by  227; 
advantages  of  231,  291;  travelers' 
234. 

Letter  of  delegation  266. 

Letter  of  confirmation  224,  243. 

Letter  of  guarantee  249. 

Letter  of  hypothecation  166. 

Limit  of  tolerance  354. 

Limping  standard  358. 

Location  factor  determines  rate  fluc- 
tuations 42. 

Loans  by  means  of  bills  of  exchange; 
nature  and  method  150;  dollar  loan 
151;  sterling  loan  153;  burden  of  in 
financing  foreign  trade  227. 

London  market;  a  clearing  center  313; 
relations  with  foreign  banks  314; 
commission  charges  of  London 
banks  321;  discount  market  324; 
bill  brokers  328;  discount  houses 
333;  Bank  of  England  334. 

London's  supremacy,  reasons  for  358. 

Long  term  investments  358. 

Mark  46. 

Market  fluctuations  of  exchange  rates 

60. 
Mercantile  risk  allocated  by  bEla  of 

exchange  260. 
Mexican  dollar  50. 
Mint  par;  between  two  gold  coins  44, 

47;  between  gold  and  silver  coins 

48;  between  gold  coins  and  paper 

51. 
Monetary     systems;     England     45; 

France  45 ;  Germany  46. 
Money  factor  determines  par  rate  42. 

National  significance  of  bills  of  ex- 
change 35. 

Negotiable  Instruments  Law  3. 

New  York  market;  former  weakness 
of  366;  Federal  Reserve  Act  373; 
present  discount  market  380;  posi- 
tion of  banks  383;  bill  brokers  387; 


operations  of  Federal  Reserve  Rank 
390;  rates  of  discount  393;  forward 
rate  393;  compared  with  Loudon 
402. 
Notification  of  advice  255. 

Official  Bank  Rate,  London  339. 

Offsetting  debits  and  credits  IS. 

Open  account  sales,  remittances  for 
269. 

Open  market  rate  of  discount;  Lon- 
don 331;  New  York  392. 

Option  of  prepayment  188. 

Order  bill  of  lading  164. 

Paper  money;  par  of  exchange  with 

gold  52;  depreciation  of  52;  effect 

on  commerce  113. 
Par  of  exchange.   See  Mint  Par. 
Partial  deliveries  with  pajmaent  bill 

180. 
Payment    bills    not    marketable    93. 

See  Documentary  Payment  Bill. 
Payee  3. 

Pegging  the  rate  of  exchange  126. 
Philippine  exchange  75. 
Pound  sterling  45.    <See  Sterling. 
Prepayment  of  acceptance  186. 
Price  levels;  effect  on  rates  of  exchange 

55. 
Protest  6,  171. 
Purchasing  power  par  55. 

Quantity  of  money  and  prices  124. 
Quotation  of  rates,  methods  47,  62. 

Rate  of  exchange;  definition  40;  de- 
mand rate  40;  cable  rate  84;  com- 
mercial rate  90;  banker's  long  rate 
88. 

Rate  fluctuations;  customary  quota- 
tions of  47;  caused  by  supply  and 
demand  59;  kow  affected  by  specu- 
lation 108;  relation  to  balance  of 
trade  109;  effect  on  commerce  111; 
caused  by  depreciated  currency 
113;  effect  on  national  welfare  118; 
effect  on  borrowing  transactions 
154;  means  of  avoiding  risk  of  282. 

Rediscount  agency;  function  of  335; 
formerly  lacking  in  New  York  370. 

Rediscount  policy  of  London  banks 


INDEX 


409 


335;  of  Bank  of  England  335;  of 
Federal  Reserve  Bank  396. 

Rediscount  rate;  relation  to  bill  mar- 
ket 338;  to  discount  rates  395. 

Reichsbank,  devices  for  controlling 
gold  movements  357. 

Retirement  rate  of  interest  187. 

Return  draft  payment  196. 

Revolving  credit  241. 

Rights  of  parties  to  bill  of  exchange 
5,7. 

Risk  of  exchange;  defined  139;  how 
avoided  282. 

Rubber  stamp  clauses  203. 

Rupee  exchange  76. 

Sales  on  book  account  269. 

Scale  of  rate  quotations  62. 

Service  of  loan  29. 

Services  of  correspondent  banks  317. 

Shanghai  exchange  49. 

Short  selling  103;  by  means  of  finance 
bill  152. 

Silver  exchanges;  par  with  gold  49; 
how  quoted  50;  effect  on  commerce 
116. 

South  American  markets;  use  of  re- 
turn draft  194. 

Specie  points;  definition  64;  deter- 
mination of  66;  with  gold  exchange 
standard  74;  relation  to  commerce 
111;  manipulated  by  bank  policy 
353. 

Speculation  103. 

Spread  of  exchange  rates  95. 

Stamp  taxes  on  bills  89,  267. 

Standard  money  43. 

Sterling  bill;  use  in  triangular  ex- 
change 37;  use  as  return  draft  197; 
general  use  of  sterling  long  bill  358; 
Buperiority  of  139. 


Sterling  credit;  established  for  lending 
purposes  149;  commercial  use  of 
215. 

Sterling  exchange;  why  the  chief 
financing  agency  358. 

Sterling  rates;  par  44;  methods  of 
quoting  47;  influenced  by  policy  of 
Bank  of  England  345. 

Sterling  loan  153. 

Storage  of  goods;  with  documentary 
bill  180. 

Straight  bill  of  lading  164. 

Straits  Settlements  76. 

Supply  and  demand;  determinant  of 
sight  rate  of  exchange  61,  80;  influ- 
enced by  discount  rate  343 ;  sources 
of  summarized  32. 

Tael  49.  _ 

Telegraphic  transfer.  See  Cable. 

Terms  of  sale;  customary  in  foreign 
trade  260;  relation  to  bills  of  ex- 
change 262;  summary  of  270. 

Trade  acceptance  91,  93. 

Trade  bills  not  discountable  326. 

Trade,  foreign.  See  Commerce;  Bal- 
ance of  Payment. 

Trade  in  securities  24. 

Trade  statement  of  United  States  33. 

Travelers'  checks  238. 

Travelers'  expenditures,  relation  to 
exchange  market  30. 

Travelers'  letter  of  credit  234. 

Triangular  exchange  37. 

Trust  receipt  182. 

Uncovered  futures  104. 
United  States.  See  New  York. 

Warehousing  by  banker  182. 
Without  recourse  254,  263. 


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